The Evolution of Taxation of Software in International Transactions: Insights from a Landmark Supreme Court Ruling and Subsequent Developments

Taxation of income from software in international transactions has been a contentious issue in India since many years. The debate primarily focused on considering transactions as “royalty” or “business” income. The revenue has often contended that the payments made to Non-residents shall be taxed as Royalty, irrespective of the arrangement between the vendor and the end user or a reseller, and taxes shall be withheld by the entities making the payment. The taxpayer's stand has generally been that characterization of the same as royalty or business profits, especially under the applicable DTAA, should be based on the nature and extent of rights granted as per the agreement.

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In a landmark ruling, the Hon’ble Supreme Court (SC) in March 2021 ruled in the case of Engineering Analysis Centre of Excellence Private Limited vs. CIT (2021) 432 ITR 471, that payments by resident Indian end users or distributors (both residents and NR) of shrink-wrapped software, is not royalty under the DTAAs.

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The Hon’ble SC concluded that the payer who gets non-exclusive, non-transferable and restricted right of the software, makes payment for the copyrighted article and not for use of the “copyright”. Similarly, where the end user does not obtain any rights in the copyright under the license agreement, internal use as permitted by the license does not involve grant of a right in the copyright. The SC concurred with the view that payment made by end users and distributors is a payment for sale of goods and not for grant of license in copyright.

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The SC decided on the appeal by categorising the payments in the following four categories of arrangement:

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Category 1 – Sale of software directly to an end user by a Non Resident (NR)

Category 2 – Sale of software by an NR to Indian distributors for resale to end customers in India

Category 3 – Sale of software by an NR to a foreign distributor for resale to end customers in India

Category 4 – Software bundled with hardware and sold by foreign suppliers to Indian distributors or end users

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For all four categories, the Hon’ble SC ruled that payments by resident Indian end users or distributors of shrink-wrapped software, is not royalty under the DTAAs. The Honble Court further held that the nomenclature given to a transaction is not decisive factor in determining the taxability and exact nature of the transaction is required to be evaluated in light of the overall terms of the agreement.

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In the above landmark ruling, the ‘Hon’ble SC had put an end to this controversy thereby providing much needed clarity on the taxation of such transactions in India. This shift marks a substantial change in the tax landscape, providing clarity on the taxation of software payments by Indian entities to non-resident vendors.

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Further, this SC ruling also highlights that DTAA entitlement is subject to conditions and the payee is obligated to furnish certain documents to the payor such as a Tax Residency Certificate (TRC), Form 10F and No PE declaration for obtaining the benefit.

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Recently, in the case of GE India Technology Centre Private Limited, the revenue had filed a review petition. In an important development, a three judges Bench of the Hon’ble SC dismissed the review petitions filed by the Revenue. The Hon’ble SC dismissed the petition due to inordinate delay in filing the review petition, which was not satisfactorily explained. Also, having gone through the review petition and the connected papers, the Hon’ble SC did not find any justifiable reason to entertain the review petition.

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The dismissal of the revenue department's review petition by the Hon’ble SC brings much-needed finality to the taxation of off-the-shelf software supplied by NR into India.