Microsoft case - Macro-hard implications!

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Apr 6: THE order of the CIT (Appeals) in the Microsoft case is the latest hot news, in the income tax arena. Ever since TIOL broke this story two days back, all television channels have been carrying news reports on this 'breaking story". We will try to understand the macro implications arising out of this rather unusual order of the CIT (Appeals)

The appellate order in brief……..
The CIT(A) has held that GraceMac Corp, a Nevada based company and a subsidiary of MS Corp is liable to pay tax in India on the 'royalty income" earned out of licensing of the Microsoft software products to Indian customers.

Microsoft and GraceMac had entered into a 'parent-subsidiary" agreement under which Microsoft Corp had granted GraceMac, proprietary and ownership right in license and in intellectual property (IPR) of Microsoft software and hardware products. Based on this agreement, GraceMac had been licensing the Microsoft products to India and had been taking a view that the royalty income earned by is could n not be taxed in India and had hence, been filing IT returns showing 'Nil" income.

The IT Department took a view that software is an invention as its development requires highly technical manpower with highly sophisticated infrastructure and classifying it under the category of “secret formula or process", the Department levied income tax under Section 9(1)(vi) of the Income tax Act 1961, read with Article 12 of the Double Taxation Avoidance Agreement. On appeal, the CIT (Appeals) has upheld the view of the AO and has levied interest as well. TIOL has estimated that the liability on GraceMac could run to over Rs 700 crores.

As the appellate order is based on Section 9(1)(vi) of the IT Act and Article 12 of the DTAA, it becomes important for us to broadly understand these…..

Section 9(1)(vi) lists down the incomes which are deemed to arise or accrue in India and the list includes income by way of royalty payable by a person who is a resident, except where the royalty is payable in respect of any right, property or information used or services utilized for the purposes of a business or profession carried on by such person outside India or for the purposes of making or earning any income from any source outside India or by a person who is a non-resident, where the royalty is payable in respect of any right, property or information used or services utilised for the purposes of a business or profession carried on by such person in India, or for the purposes of making or earning any income from any source in India.

The Explanation 2 to Section 6(1)(vi) which is perhaps what has gone against Grace Mac reads as follows:
Explanation 2.—For the purposes of this clause, “royalty" means consideration (including any lump sum consideration but excluding any consideration which would be the income of the recipient chargeable under the head “Capital gains") for—

(i) the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property;

(ii) the imparting of any information concerning the working of, or the use of, a patent, invention, model, design, secret formula or process or trade mark or similar property;

(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or similar property;

(iv) the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill;

(iva) the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in Section 44BB.

(v) the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting, but not including consideration for the sale, distribution or exhibition of cinematographic films; or

(vi) the rendering of any services in connection with the activities referred to in sub-clauses (i) to [(iv), (iva) and].

(v) The Income Tax Department has also gone by Article 12(3)(a) of the DTAA between India and the USA, which states that the term "royalties" as used in the Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films or films or tapes used for television or radio broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience.

Based on a combined interpretation of the said Section 9(1)(vi) read with Article 12 of the DTAA, the Department has concluded that GraceMac is liable for income tax on the 'royalties" earned by it in terms of the licence fee charged to its Indian customers, which has been worked out at 35% to 40% of the license fee received.

This decision of the CIT (A) throws up several interesting issues, which would have a profound impact on the Indian industry as a whole, given the fact that a lot of software licenses get imported by the Indian companies. Here are some of my immediate reactions to this path breaking decision of the Appellate Authority in the Microsoft case……..

The fundamental issue involved here seems to be that, the Income tax Department does not recognize the fact 'canned software" is goods, even after the Supreme Court"s historic judgment in the TCS case [2004-TIOL-87-SC-CT-LB]. The Income tax Department might argue that the Apex Court"s decision on 'canned software" being goods, was given in the context of the sales tax law, which is not a central law.

Even the Central Excise Act, 1944 and the Customs Act, 1962 treat 'canned software" as 'goods". After all, what Microsoft sells to its Indian customers is 'canned software". I don"t appreciate as to how the interpretation for purposes of income tax could be so radically different from the one that has been adopted for purposes of central excise, customs and VAT. One can only be amused at the efforts of the Income tax Department to attribute a new meaning to 'software" with the sole objective of subjecting cross border transactions to tax, in India, completely undermining the Apex Court"s decision in the TCS case. In my strong opinion, the provisions of DTAA cannot be invoked for a sale transaction.

Viewed from another angle, it cannot be doubted that GraceMac had only 'licensed" the MS software products, to its Indian customers. Under the Indian law, licensing of a software product would have squarely fallen under the category of 'right to use goods" which is covered under the definition of 'deemed sale". Indian software product companies pay VAT on the sale of licenses within India, under the 'deemed sales" concept. Of course, the 2008-09 Budget has made a bold attempt to bring the value of sale of software licenses under the newly introduced 'Information Technology Software Service". Despite this attempt by the Centre to usurp the powers of the States to levy tax on 'deemed sales", there can be no doubt that 'software licenses" are goods and transfer of right to use goods would be a sale and not a service, by any stretch of imagination.

A combined study of Article 12 of the DTAA between India and the USA and Section 9(1)(vi) would indicate that the concept of 'royalties" as laid down in the said Article seems to be limited, as contrasted to the expanded concept for royalties, as laid down in Section 9(1). In my opinion, there seems to be a bit of a conflict between the provisions of the DTAA and the Income tax Act, in terms of what would constitute “royalties" in the context of the transfer of right to use software licenses by a resident of one country, to a user in another country.

It is well established that in the case of a conflict between the Income-tax Act and the provisions of DTAA, the provisions of the DTAA would prevail over provisions of Income-tax Act, as has been held by the Supreme Court in CIT v. P.V.A.L. Kulandagan Chettiar (2004-TIOL-61-SC-IT). It has also been held in CIT v. Hindustan Paper Corporation Ltd. [1994] 77 Taxman 450 (Cal),. that the provisions of the Double Taxation Avoidance Agreement (DTAA) shall always prevail even when anomaly is noticed between the provisions of the Act and the provisions of DTAA. Given this, it would be very difficult to believe that the provisions of Article 12 of the DTAA between India and the USA could be interpreted to mean that 'software" is a" secret formula or process". We have already discussed that 'canned software" is goods in the eyes of the Apex Court, and one would really need to have a 'secret formula or process" in one own"s mind to deem it otherwise.

Let"s also bear in mind the fact that Indian software product sellers / licensors (you don"t have many of them, any way) operating out of India and without a local branch in, say, the US, do not pay income tax in the USA. Ethically speaking, I don"t appreciate the view that the US software product vendors should pay tax in India, when they operate without a permanent establishment in India. After all, the DTAA covers transactions from both the sides.

I do believe that the decision of the CIT (Appeals) would get reversed at the higher adjudication levels. Given the potential of the tax that can be collected, it is very unlikely that the Department would give up this view, so easily. A very interesting battle, which would be fought right up to the Apex Court, is on the cards. There is however, one consolation though. While the Government can amend the income tax provisions retrospectively, to annul unfavorable decisions of the Apex Court (which it has been doing regularly), thankfully it cannot tinker with the DTAA which involves the US Government as well. As such, the Indian Government has enough problems related to 'agreements" with the US.

Another unrelated issue relates to the possibility of the Indian importer being asked to pay service tax, in terms of the Import of Services Rules 2005 read with Section 66A of the Finance Act 1994, in respect of the amounts paid to the foreign software vendors like Microsoft, as the licensing of the software products by the foreign players would indeed get covered under the 'Information Technology Software" service, as defined in its present form. This could result in a significant additional service tax revenue to the Government.

I am informed that the value of foreign software licenses imported into India could easily run to hundreds of crores of rupees. I am also aware a significant portion of the import of licensed software products is handled by third party importers, who in turn, sell these licenses to the ultimate users or customers. There is also a large element of downloading of canned software which happens through the Internet, whereby, a PIN or Unique used id or number is provided to the Indian customer, on payment of the agreed fee. All of these would get covered under the definition of the newly introduced 'Information Technology Software" service, forcing the importer to pay service tax.

Finally, let"s bear in mind that the foreign software vendor / licensor can still adjust the income tax paid by him, in respect of his profits in India (if at all this becomes payable) against the tax payable in his host country in terms of the provisions of the DTAA and hence, the foreign player"s overall tax liability doesn"t increase, on account of the tax paid by him, in India.

TAIL PIECE…
The market for imported software products in India is said to run to tens of hundreds of crores of rupees, involving large and medium players. A variety of business models operate in this arena, including the one involving third party players who license these software products from the original vendors and then sub-license these software products to the Indian customers. The Government is bound to significantly benefit out of this sector by levying income tax on the software vendors and service tax on the importers. I only wish that the levy of income tax and service tax on the licensing of imported software products does not kill this very industry.

While discussing international tax related issues, we shouldn"t get too 'nationalistic". We should not lose sight of the fact that most Indian companies who sell products into the US and the European countries without foreign branches do not pay tax in these countries, because of the DTAAs. A similar benefit is also available to the MNCs who sell their products in India, so long as they do not have permanent establishments in India. Statements like 'MS Corp does not pay even a penny as tax to the Indian Government" are at best, plain rhetoric.


(The author is Director of S3 Solutions)

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