Publish Date

Sep 20, 2021

Welcome Relief from Indian Withholding Tax on Software Payments

A&M Tax Advisor Weekly

In a recent landmark income tax ruling, the Supreme Court of India (“Indian SC”) has delivered a notable victory to nonresident technology companies licensing software into India. In Engineering Analysis Centre of Excellence Private Limited v. CIT, the Indian SC overruled a long standing position of the Indian Revenue Authorities and confirmed that an outbound payment by an Indian resident to a non-Indian based supplier for a copy (or a limited number of copies) of a computer program is not a “royalty,” for purposes of the royalty withholding tax provisions of the U.S. – India Double Tax Treaty. This is welcome news for U.S. software companies who sell license software to Indian customers. This article will discuss the holding in the case, specifically how licensing of software into India does not give rise to Indian withholding tax. This article will also provide proactive steps that you can take to ensure that withholding tax is not erroneously withheld by your Indian customers for software licenses as well as procedures that you can follow in order to claim a refund for prior amounts withheld by your Indian customers. A&M Tax and ELP India are here to assist you in taking these proactive steps.

The Indian SC ruling suggests that the Indian Revenue Authorities have finally aligned their views regarding the royalty provisions of India’s tax treaties with global practices and in particular the U.S. tax treatment. This now-prominent case will also impact the treatment of software payments under the domestic withholding tax law of India (i.e., in the absence of an applicable double tax treaty).

The ruling signifies a welcome change for U.S. tech companies selling software into India as, going forward, no income tax will be required to be withheld by Indian customers making payments to such companies for the license of computer software programs. In situations where tax has been previous withheld in prior years, U.S. software suppliers should strongly consider retroactively claiming a refund on the basis of the Indian SC ruling, particularly where such withholding tax is administered between related parties. Further, the ruling will provide major relief to the U.S., and other foreign companies, in current pending tax litigation in India with respect to the Indian Revenue Authorities’ now obsolete position on their right to assert a withholding obligation. The mechanics of these opportunities are discussed in further detail below.

As per the figures reported by the Office of the United States Trade Representatives, India imported USD 24.3 billion worth of computer software, audio, and visual related products in 2019. Thus, considering the quantum of imports from the U.S., the ruling will likely play a pivotal role in boosting the trade relations between India and the United States.

A Brief History of the “Controversy”

“Tax deduction at source” is a tax collection mechanism in India whereby a certain percentage of consideration is withheld and deposited with the Government as tax on behalf of the recipient of certain types of covered payments, including software license fees. This tax would commonly be referred to as a withholding tax on “fixed, determinable, annual, or period” (“FDAP”) income in U.S. tax-speak. One of the most controversial tax disputes prevalent in India for many years concerned whether payments related to the license of software should be treated as consideration for “the sale of goods” versus rights to intellectual property (i.e., a royalty). This is an important distinction, as Indian withholding tax only applies to payments towards royalty (i.e., payments which are considered as royalty), and does not apply to the price for the purchase of goods.

The implication of the two-decade long legal debate was that Indian-based licensees of software programs provided by non-Indian suppliers were required to withhold tax on the software license fees. In general, non-Indian software companies were strongly of the view that the purchase of software should constitute the purchase of goods and therefore, should be exempt from any Indian withholding tax. However, the Indian Revenue Authorities consistently applied a revenue-friendly position maintaining that software payments should be treated as a royalty for the use of a copyright/intellectual property and should attract Indian withholding tax in a cross-border scenario.

For U.S. software companies, this withholding tax burden could be highly problematic due to the U.S. foreign tax credit limitation and sourcing rules. Many companies were unable to claim full foreign tax credits for the taxes withheld on the sale of computer software into India (due to NOLs, lack of foreign-source income, etc.). Thus, the Indian withholding tax was often a non-recoverable, sunk cost for these U.S. software companies.

Legal Issue-The Indian SC Reverses Course

Quoting the Indian SC, the prior cases in question have had a “checkered history” on account of conflicting judgments from two different State Courts. The diverging views largely revolved around the interpretation of the word “royalty” as defined in the Income Tax Act of 1961, the Indian Double Tax Avoidance Agreements (“DTAAs”; e.g., Tax Treaties), and as understood in the context of copyright law.
Under the Indian Income Tax Act, “royalty” is explained to include “transfer of all or any right for use or right to use a computer software (including granting of a license) irrespective of the medium through which such right is transferred”. The Revenue Authorities contended that the payments made against the software licenses amount to a “royalty”, thus necessitating withholding of tax in accordance with the domestic tax laws in India.

However, under the India-U.S. Tax Treaty (“DTAA”), a royalty is defined as “payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work,” which was interpreted by the Indian Revenue Authorities to be inclusive of a computer program or software. Taxpayers contended that a supplier of software essentially licenses “shrink wrapped software that contains an embedded computer program or code” and not the “computer program” itself. Since the definition of the term “royalties” under the DTAA does not extend to derivative products of the copyright (i.e., the copyrighted material or product itself) payments made by the Indian customers for the computer software should not amount to a “royalty” under the DTAA definition. In such cases, the DTAA would prevail over domestic tax law to the extent it is more beneficial to the taxpayer. Hence, payments made for a computer software license could not be taxed in India unless the nonresident supplier has a permanent establishment in India.

Considering the above legal background, the Indian SC analyzed various arrangements whereby non-resident companies licensed computer software, either directly to Indian end-users or through distributors. The Indian Supreme Court has broadly categorized the software purchase arrangements to be as follows:

  1. Indian end-user purchases computer software directly from a nonresident supplier or manufacturer.
  2. Indian distributors purchase computer software directly from a nonresident supplier or manufacturer and resell the same to Indian end-user.
  3. Foreign distributors purchase computer software directly from a nonresident supplier or manufacturer and resell the same to Indian end-user.
  4. Computer software is affixed onto hardware and is sold as an integrated unit/equipment by nonresident suppliers to Indian distributors or end-users.

Based on the various license agreements evaluated by the Indian SC, it was apparent that on license of computer software, the end-user in India only receives a limited license to use the computer software by itself, with no right to sub-license, lease, reverse-engineer, make copies, etc. Further, in cases where the computer software is sold through distributors/re-marketers, the distributor receives only a non-exclusive, non-transferable license to resell the computer software.

While evaluating the issue, the Indian SC also referred to the following pivotal conclusions within the Copyright Act, 1957:

  • A license from a copyright owner, conferring no proprietary interest on the licensee, does not entail parting with the copyright.
  • There is a difference between ‘a copyright in an original work’ and ‘a copyrighted article’ itself.

Concluding the legal debate, the Indian SC observed that the term “transfer of rights” in context of copyrights essentially means the same thing under the international tax conventions as well as the domestic tax law of India (i.e., “transfer of rights of the copyright embedded in the software and not the software itself”). Thus, foreign/U.S. companies who license software into India should not be subject to withholding tax, regardless of whether the seller has a tax treaty with India.

A&M Tax & ELP India Recommend

  • U.S. software suppliers should evaluate the software license agreements/end user license agreements and depending on the results of such analysis should either:
    • Reach out to their respective Indian customers to insist that they discontinue withholding taxes in India on software license fees, or
    • Consider modifying the existing agreements based on the Indian SC decision, to mitigate potential withholding taxes that may still be due, despite the recent ruling.  For example, a non-resident supplier of software might consider enhancing limitations and restrictions on the grant of their software to minimize the chance that such license is still a royalty.
  • If the applicability of the above Indian SC decision remains contentious due to factual disparity, or where the Indian distributors and/or end-users still proceed to conservatively withhold tax in India, the U.S. software licensor should file an application with the Indian tax authorities to obtain a withholding exemption certificate (“no-withholding certificate,” locally).
  • For more complex matters, nonresident companies should consider the option of seeking an advance ruling from the Indian Board of Advance Ruling.
  • In cases where Indian audit/assessment proceedings have been ongoing and tax returns or amended tax returns have yet to be filed, U.S. software licensors should consider claiming a refund on such returns in India in light of the above Indian SC’s recent decision.
  • In situations where a U.S. software licensor required a gross up payment based on Indian withholding taxes payable by the Indian customer, the Indian customer may consider asking the U.S. software licensor to apply for a refund of the taxes withheld and come to a commercial agreement as to how the refunded taxes can be fairly allocated between the two companies.