General

International transactions in computer software have grown rapidly in recent years. These transactions vary considerably. For example:

1. Computer software can be systems or applications software. Systems software deals with the operational system of the computer to make it work, while application software perform specific tasks, e.g., spreadsheet, word processing, etc. They may be pre-packaged as a product, or written specifically or tailored to a particular user’s needs. They may be sold either as a standard item in a "shrink wrapped" (or "unbundled") form, or pre-loaded (or "bundled") in the hardware itself. They may be transferred through a variety of media (e.g., hardcopy, floppy disk, tape, CD-Rom, etc.).

2. Business software developers typically grant the buyer the rights to subsequent enhancements, maintenance and support. Authorised resellers or distributors provide these products and services to customers as standard packages for a lump sum payment, periodic payments, or sometimes payment based on usage. The transfers of these software rights could be exclusive or non-exclusive, and may be either full rights or rights limited in geographic scope or duration.

3. The software developer may market his product by :

1. Licensing his rights to reproduce and distribute the software or
    

2. Reproducing it himself for sale to customers. If they are standard packages, they may be sold as a product through regular sales outlets. They may also be downloaded from the Internet or "web-wrapped".

Taxability – OECD view

Taxability of software transactions have thus, been a matter of debate world over in recent times. The OECD, after a detailed study, has amended the Commentary to Article 12 of its Model treaty to incorporate the following. principles:

• Payments made for the acquisition of partial rights in the copyright (without the transfer or fully alienating the copyrights rights) will represent a royalty where the consideration is for granting of rights to use the programme in a manner that would, without such license, constitute an infringement of copyright.
   

• Where consideration is paid for the transfer of the full ownership of the rights in the copyright, the payments do not represent ‘Royalty’ but generally business income or Capital Gains.
   

• Payments made for right acquired in relation to copyright limited to those necessary to enable the user to operate the programme; i.e., if it is an acquisition of a copyrighted article, the payment is not ‘Royalty’, but taxable as business profits.
   

• In a case where the programmer also supplies information about ideas and principles underlying the programme, such as logic, algorithms or programming languages or techniques, the payments made shall be ‘Royalty’ to the extent they represent consideration for use of or the right to use, secret formulas or special information.
   

• Payments under mixed contracts

Mixed contracts include sales of computer hardware with built-in or embedded software. The taxability of such transactions as per OECD should be as follows:

1. Whenever the contract is a mixed contract, the appropriate course to take is, in principle, to break down, on the basis of information contained in contract by means of a reasonable apportionment, the whole amount of the stipulated consideration according to the various parts of what is being provided under the contract, and to apply to each part of it so determined the taxation treatment proper thereto.
    

2. If, however one part of what is being provided constitutes by far the principle purpose of the contract and the other parts stipulated therein are only of an ancillary and largely unimportant character, then it seems possible to apply to the whole amount of the consideration the treatment applicable to the principle part.

It may be pertinent to note here that in the treaties entered into by India with Malaysia, Namibia, Russia, Trinidad & Tobago, Turkmenistan & Kyrgyz Republic definition of royalties specifically includes consideration for use of computer software.

Taxability under I.T. Act, 1961

The taxability under the Act should be no different than that prescribed in the OECD Commentary as discussed above. However, some assessing officers have been erroneously taking the stand that the definition of "royalty" u/s. 9(1)(vi) is very wide and covers payments for all types of software whether shrink-wrapped or customised or otherwise.
 

Let us, thus, examine the issues which arise with regard to taxability of software in the context of the I.T. Act, 1961:

1. Second proviso to section 9(1)(vi) (which was added w.e.f. 1-4-1991) excludes from the scope of "royalty" lump sum payment by a resident to a non-resident manufacturer for transfer of all or any rights (including the grant of licence) in respect of a computer software supplied alongwith a computer based equipment under any scheme approved by the policy on Computer Software Export, Software Development & Training, 1986 of the Government of India.

An issue which may arise as a result of this proviso is that does this exclusion mean that payment for all other software are included in the definition of "royalty" u/s. 9(1)(vi). The answer to this is a clear no and is found in Circular 588 dt. 2-1-1991 of CBDT which was a pre cursor to the insertion of the second proviso to section 9(1)(vi). This Circular was issued as on software imports both customs duty & income tax were being charged. To relieve this double taxation, this Circular provided that :

1. Lump sum payment for systems software supplied by the manufacturer along with the hardware itself would be subjected only to customs duty and not to income-tax.
    

2. Application software forming part of an approved software export scheme would be subjected only to income-tax on the licenser or seller and not custom duty.
    

3. Where a tax-payer, engaged in the business of export of software for computer application, imports any systems software, supplied by the manufacturer of the computer hardware, along with the hardware itself, the lump sum payment made to the foreign supplier will not be liable to tax. Such lump sum payments are allowed to be made without deduction of tax at source under sec. 195(1) of the I.T. Act, 1961.

2. The definition of "royalty" u/s. 9(1)(vi) includes consideration for:

1. transfer of all or any rights (including the granting of a licence) in respect of a patent, secret formula or process or trademark or similar property;
    

2. ———————————————————————————

5. transfer of all or any rights (including the granting of a licence) in respect of any copyright,   ——————————————————,"

3. Payment for licence to use software are payment for a "product" and thus not "royalty" in view of the following:

1. The ITAT in the following. recent decisions has consistently held that payment for use of "Shrink Wrapped Software" is a payment for a copyrighted article and not a payment for copyrights (Samsung Electronics (94 ITD 91 (Bangalore)), Lucent Technologies (92 TTJ 163) & TCS (271 ITR 401 – SC)), Nokia, Ericsson & Motorola (95 ITD 269) Delhi – SB), Sonata Information Technology Ltd. (ITA No. 3702/Mum/2004) Un-reported). This view is also supported by unreported decision of ITAT in Lotus Devt. (Asia Pacific) Pte. Ltd. vs. Dy. Dir. of I.T. (ITA Nos. 564 to 566/Del/05 dt.
   28-4-2006).
    

2. Further, the courts have held that payments for access to an online database was not payment of "royalty" (Wipro Ltd. vs. ITO – 92 TTJ 796)
    

3. The Mumbai Tribunal in R.S. Bhagwat vs. ACIT (78 TTJ 641) has held that an assessee in the manufacture and production of software was eligible for deduction u/s. 80-I as software is "goods" or "product";
    

4. In the Bombay Sales Tax Act, the software packages are listed as "goods" in Entry 26(5). The Supreme Court in TCS – (271 ITR 401 (SC) held that canned & customized software are goods for purposes of sales tax.
    

5. In Central Excise Tariff Act, 1985, Entry 85.24 includes "software". The Hon'ble Supreme Court in the case of SBI (115 ELT 597) held under Customs Act that right to use software countrywide and right to reproduce software are two different things and the licence fees for country-wide use cannot be considered as charges for right to reproduce the software.
    

6. The Hon'ble Supreme Court in case of ACC Ltd. (128 ELT 21) held that computer programmes are goods for the purpose of Customs duty.
    

7. Section 1.861 of the US IRC has categorised all software transactions & analysed them. Its findings given with examples are more or less in line with the OECD’s conclusions discussed above.

4. Where software is customized, a possible view is that the customization charges are FTS while the software charges are business profits. In other words, the principles discussed above for mixed contracts should apply in such contracts. This, however, would depend on the intent of the parties as to which party is to mean the copyright rights in the computer programme and how the risks of loss are allocated between the parities. For example, if the copyright rights do not belong to person providing services, and risk of loss is not borne by person providing services, it will be a case of FTS.
    

5. Where software is adapted from another software, the adaptation charges would constitute royalty and the software charges would be business profits. Again the principles applicable to mixed contracts should apply.