Software Tax Case: Government Could Be Staring At Significant Refunds

This week the Supreme Court put to rest a two decade-old tax dispute relating to cross-border software transactions. The court denied the revenue department’s claim that payments for such transactions should be taxed as ‘royalty’.

In doing so, the bench overturned the Karnataka High Court order in the Samsung Electronics’ case, which was applied by the tax department in majority of the cases. For instance: IBM India Ltd., Hewlett Packard India, Mphasis Ltd., Sonata Software Ltd., GE India etc.

There are two key outcomes of this ruling.

One, the government will have to issue refunds to all companies who had paid the tax demand in the last 20 years. The refund due to just IBM India is to the tune of Rs 1,300 crore and the total outgo for the government can be anywhere between Rs 15,000 crore and Rs 20,000 crore, a lawyer involved in the matter told BloombergQuint on the condition of anonymity.

And two, some of these cross-border transactions may now come within the ambit of digital tax, known as Equalisation Levy.

Relief For Taxpayers

The dispute revolved around taxability of cross-border software payments. Specifically, whether the payment received by a non-resident for giving licence of the computer software to a buyer in India is taxable as royalty or sale receipt.

Broadly, the court was dealing with four kinds of transactions:

Sale of software by a non-resident directly to an end user.
Sale of software by a non-resident to Indian distributors for resale to end customers in India.
Sale of software by a non-resident to a foreign distributor for resale to end customers in India.
Software bundled with hardware and sold by foreign suppliers to Indian distributors or end users.

The court examined the provisions of the Copyright Act, the Income Tax Act and the distribution agreements between the companies.

It noted that:

What was granted to the distributor was a right to resell a computer software with an express stipulation that no copyright in the computer program was transferred to it or the end-user who only had the right to use the computer program.
Even though the definition of ‘royalty’ was retrospectively amended in 2012 to include right to use a computer software, what will prevail are tax treaties which India has signed with various countries.
Under the tax treaties, ‘royalty’ includes payments made for the use or right to use any copyright. And since these transactions didn’t lead to a transfer of copyright, payments for them won’t qualify as ‘royalty’ under the tax treaties.

In giving this relief to taxpayers, the apex court has made another welcome conclusion, Ajay Rotti, partner at tax consultancy Dhruva Advisors, said. Rotti pointed to a recent decision by the court where it was held that the obligation to withhold taxes is not affected by tax treaties.

Relying on this conclusion, the tax department had argued in the software matter that taxes had to be deducted irrespective of the double tax avoidance treaties and the overseas vendors could claim a refund if the sum was not taxable.

The Supreme Court has held that the PILCOM ruling was in the context of a special provision and hence would not apply in all payments to non-residents. This observation of the Supreme Court has a larger bearing than just on software payments since PILCOM ruling had created considerable confusion.

Ajay Rotti, Partner, Dhruva Advisors

The Refund Situation

There were 107 companies that reached the Supreme Court but during the period these cases were pending, many more taxpayers lost at the Income Tax Appellate Tribunals and high courts.

The Bengaluru ITAT has been confirming the Karnataka High Court order as a binding principle, and when matters reached the high court, taxpayers were asked to deposit 100% of the demand, Mukesh Butani, managing partner at BMR Legal, said. Besides the appeals which reached the Supreme Court, he pointed out, significant amounts are locked up in litigation at the ITATs and high courts.

Now both these forums will just dispose of cases in line with the apex court’s judgment which is a binding law. The whole objective to divide the case into four categories before the Supreme Court was to potentially address most if not all situations of software, including those pending before other forums.

Mukesh Butani, Managing Partner, BMR Legal

There is a statutory mandate that says the tax department has to give effect to a court order, Butani added. "So the government will have to either issue refunds or set it off against any existing liability of the companies who have paid up."

The Equalisation Levy Tangle

Last year, the government introduced a 2% tax on sale of goods as well as services that take place through non-resident digital operators.

This year, the government clarified its scope saying the levy is applicable to digital platform services, digital content sales, digital sales of a company’s own goods, data-related services, software-as-a-service, etc. Also, services which are subject to tax as royalty under the income tax law will be out of the ambit of equalisation levy.

Now that the apex court has said that payments for cross-border software transactions won’t amount to royalty, they will be subject to equalisation levy, Rotti said.

If the payment is to an entity from a non-treaty country, it will be treated as royalty under the domestic law owing to the retrospective amendment. In such cases, equalisation levy will not apply, Rotti explained.