Provision of section 9(1)(vi) of IT Act 1961 on royalty on sale of software

IN THE INCOME TAX APPELLATE TRIBUNAL

DELHI BENCH ‘H’: NEW DELHI

BEFORE SHRI I.C.SUDHIR, JUDICIAL MEMBER AND

SHRI TARVINDER SINGH KAPOOR, ACCOUNTANT MEMBER

ITA No.6092/Del/2012

Assessment Year: 2009-10

M/s Microsoft Regional Sales

Corporation, USA

C/o Mr.Ashwin Ravindranath,

Partner, SRBC & Associates,

Golf View Corporate Tower B,

Sector-42, Sector Road,

Gurgaon,

Haryana.

PAN: AADCA1638A.

(Appellant)

Vs.

Additional Director of Income-tax,

International Taxation,

Range-3,

New Delhi.

 (Respondent)

Appellant by: Shri Nageshwar Rao, Advocate and Shri Rahul Garg & Shri Shailesh

Kumar, CAs.

Respondent by: Shri D.K.Gupta, CIT-DR.

ORDER

PER I.C.SUDHIR, JM:

The assessee has impugned action of learned Dispute Resolution Panel (‘DRP’) confirming the additions proposed by the Assessing Officer in the draft assessment order as against the returned income by holding that the revenue earned by the assessee from sale of Microsoft software products to the Indian distributors is taxable in the hands of the assessee as royalty under the provisions of Section 9(1)(vi) of the Income-tax Act, 1961. This action of the learned DRP has been questioned on several grounds. Besides, the assessee has also questioned initiation of penalty proceedings under Section 271(1)(c) of the Act and levy of interest under Section 234B of the Act.

2. We have heard and considered the arguments advanced by the parties and have gone through orders of the authorities below, material available on record and the decisions relied upon. The submission of the learned AR, at the outset, remained that the issue raised in the grounds regarding chargeability of income as royalty is fully covered by the decision of Delhi Bench of the Tribunal in the case of the assessee itself for the assessment years 2002-03 to 2008-09.

3. The facts in brief are that Microsoft Regional Sales Corporation (‘MRSC’ in short), the assessee, is a company incorporated in USA and is a wholly owned subsidiary of M/s Microsoft Corporation, USA (MS Corp). The assessee is engaged in the business of distribution of Microsoft retail products in the Asia Pacific region, including India. The assessee is engaged in selling/licensing of software through independent distributors to the end users under the End User License Agreement (EULA). The consideration received by the assessee from the distributors in India has not been offered to tax in India on the basis that they are business receipts and are not taxable in the absence of a permanent establishment (PE) in India.

4. MS Corp is the sole owner of intellectual property rights vested in Microsoft software. It has granted exclusive license to manufacture and distribute Microsoft products to one of its wholly owned subsidiaries, M/s Gracemac (now merged with MOL Corporation), which, in turn, granted similar non-exclusive rights to its wholly owned subsidiaries, Microsoft Operations Pte.Ltd., Singapore (MO Singapore) to manufacture Microsoft products in Singapore and distribute such products in Asia (excluding non-English language products in China and Taiwan). The assessee has been appointed as a distributor of Microsoft products in India by MO Singapore.

5. The sale proceeds received by the assessee were treated as royalty income and assessed accordingly in earlier assessment years since AY 1999-2000. The same was confirmed by the learned CIT(A) in his consolidated order dated 14.01.2005 for AY 1999-2000 to 2001-02. The Tribunal in its decision dated 26.10.2010 has deleted the addition of the receipts as royalty in the case of MRSC and confirmed the same addition in the hands of M/s Gracemac. The department has preferred an appeal before the Hon'ble Delhi High Court. In this year also, the facts of the case are same as in earlier years, therefore, relying on the stand taken by the department in the earlier years, the Assessing Officer has treated the entire receipts from licensing of Microsoft products to Indian distributors as royalty income in the hands of the assessee and has taxed accordingly. The learned DRP has approved this action of the Assessing Officer. The assessee has questioned this action of the learned DRP.

6. The learned DR has not disputed the above submission of the learned AR that the issue regarding the treatment of receipts from licensing of Microsoft products to Indian distributors as royalty income is covered by the decision of Delhi Bench of the Tribunal in the case of assessee itself for the earlier assessment years including AY 2007-08 and 2008-09. A copy of this order dated 29.02.2012 of the Tribunal in AY 2007-08 and 2008-09 in ITA No.5477 & 5478/Del/2011 has been made available on the record. He has, however, placed reliance on the orders of authorities below.

7. Having gone through the above order dated 29.02.2012 of the Tribunal in the case of the assessee itself for the AY 2007-08 and 2008- 09 (supra), we find that an identical issue has been decided in favour of the assessee under similar set of facts and circumstances. The authorities below have held that the payment made by the Indian distributors is towards the use of copyright and not for the purchase of copyrighted article and, therefore, the same is royalty under Section 9(1)(vi) of the Act. They have also held that the amount received by the assessee fulfilled the conditions of Section 9(1)(vi) of the Act and, hence, taxable as royalty in India. They have held that the consideration received by the assessee was on account of licensing of software and not on sales of software and that the amount received by the assessee is taxable as royalty in India even though the assessee does not have any permanent establishment (PE) in India. They have held further that the consideration received by the assessee is payment for a ‘process’ and is covered by Section 9(1)(vi) of the Act.

They have held that the consideration received for use of software is towards consideration for use of patented article and inventions. As per the authorities below, the payments made for import of software are royalty payments and the only exception provided is for computer software supplied by a non-resident manufacturer along with computer or computer based equipment under any scheme approved under the policy of Computer Software Export, Software Development and Training, 1986 of the Government of India. They have observed that the assessee possesses right in copyright, which it can enforce in India, if any violation is noticed by it. The contention of the assessee remained that the authorities below have failed to appreciate this material fact that the owner of copyright in Microsoft software products is Microsoft Corporation (MS Corp) and legal action against the violation of a copyright can be undertaken only by the owner of copyright. Without prejudice to this contention, it was submitted further that the right of the owner of the copyright to take legal action, would not alter the nature of the transaction from the sale of a copyrighted article to transfer of a copyright. The assessee contended further that the learned DRP has erred in observing that the provisions of Section 115A of the Act characterizes the income from sale of software as ‘royalty’ under the Act in case of non-resident without appreciating that Section 115 does not enlarge the scope of the term ‘royalty’ as defined in Section 9(1)(vi) of the Act. Against the observation of the learned DRP that the assessee possesses the intellectual property rights (IPR) in the software which it had further licensed to distributors disregarding the fact that the assessee was engaged in only distribution of Microsoft software products to distributors/resellers outside India and no rights have been passed by the assessee to the distributors in the entire transaction, it was further contended by the assessee that the learned DRP has erred in making observation that the definition of royalty is not ambiguous and the expression ‘copyrighted article’ does not find any mention in the Act or in the treaty. While doing so, the learned DRP has failed to appreciate that the said distinction between ‘copyrighted article’ and ‘copyright’ is recognized by OECD Commentaries, US IRS Regulations, International Tax Commentaries and by Courts in various cases like Hon'ble Jurisdictional High Court in the case of Ericsson A.B. and Nokia Networks OY. The assessee has also questioned the finding of the learned DRP upholding the draft assessment order that revenue earned by the assessee from sale of Microsoft retail products to distributors in India is royalty under Article 12 of the India US Tax Treaty and that the payments received by the assessee were deemed to arise in India under Article 12(7) of the India US Tax Treaty. While

doing so, the learned DRP has disregarded the fact that the revenue earned by the assessee is from the sale of Microsoft software products to the Indian distributors ex-warehouse Singapore. It was contended that the learned DRP has also erred in holding that the Revenue earned and received from sale of Microsoft software products by the assessee to Indian distributors is taxable in India under the provisions of Article 12(2) and Article 12(3)(a) of the India US Tax Treaty. The assessee contended that the authorities below have erred in not appreciating that the definition of royalty is different in the Act and the India US Tax treaty. The benefits available under the India US Tax Treaty would still be available to the assessee as the amendment in the Finance Act, 2012 would not impact the treaty interpretation of the term ‘royalty’ under Article 12. The authorities below have failed to appreciate that the sale of software is the sale of copyrighted article and not copyright and, accordingly, the revenue from sale of software is in the nature of business income not taxable under Article 7 of the India US Tax Treaty in the absence of the PE of the assessee in India.

They have also erred in observing that only two types of transactions in respect of computer software i.e. sale and license (letting) are recognized by the Indian laws and India US Tax Treaty and no further dissection of licensing (on the lines of OECD Commentaries) is permitted under the Indian Copyright Act, Income-tax Act and Indian Tax Treaties.

8. There is no dispute that the facts relating to the issue are similar with the facts of the case of the assessee in the AY 2002-03 to 2008-09. During the AY 2007-08 & 2008-09, the Tribunal in the case of the assessee has decided an identical issue in favour of the assessee following the earlier order of the Tribunal on the issue in the AY 2002-03 to 2006-07. After discussing the issue in detail as well as its finding for the AY 2002-03 to 2006-07, the Tribunal has decided the issue with this finding that such royalty cannot be assessed in the hands of the assessee as it will tantamount to assess the same income which has been assessed in the hands of M/s Gracemac. Though it has been held by the Tribunal that the amount was in the nature of royalty, but, it was held that the said amount cannot be assessed in the hands of the present assessee as it has been held to be taxable in the hands of M/s Gracemac Corporation. The decision of the Tribunal in the case of M/s Gracemac Corporation decided along with the assessee in the AY 1999- 2000 is reported in 132 TTJ 257 (Del). Quoting the finding of the Tribunal in the case of M/s Gracemac Corporation (supra), the Tribunal has decided an identical issue in ITA Nos.5477 & 5478/Del/2011 for AY 2007-08 and 2008-09 vide following paragraphs:

“6. The ITAT thereafter noticed the facts from the order of the Learned CIT(Appeals) in assessment year 1999-00 and other years which are common in these assessment years also. The facts noticed by the ITAT as well as the findings of the ITAT recorded in the case of M/s. Gracemac Corporation reported in 132 TTJ 257 read as under:

“4. The basic facts as found mentioned in the consolidated order passed by the CIT (A) in respect of assessment years 1999-2000, 2000-01 and 2001-02 are as under:-

“4. Facts of the case

The Appellant is a company incorporated in US and is a wholly owned subsidiary ("WOS") of Microsoft Corporation, USA ("MS Corp") with a branch in Singapore. The operating structure of the distribution model along with the flow of distribution rights from MS Corp to Appellant through Gracemac Corporation, USA ("Gracemac") and Microsoft Operations Pte Limited, Singapore (‘MO") was explained by appellant as follows:

Gracemac is a company incorporated under the laws of USA on September 23, 1994 having its registered office at 300 South Fourth Street, Suite 1100, Las Vegas, Nevada, USA-89109. Gracemac is a WOS of MS Corp. MS Corp entered into a Parent Subsidiary agreement ("PSA"') with Gracemac on January 1, 1999 wherein MS Corp had granted Gracemac the:

a) exclusive license to manufacture Microsoft products         

b) exclusive license to distribute the products so manufactured directly to retailers or to MS Corp or to subsidiaries of MS Corp; and

c) exclusive right to license any third party to directly grant customers the right to reproduce Microsoft software products for internal use.

In lieu of the abovementioned rights, Gracemac has issued its entire share capital to MS Corp.

In pursuance of the rights granted under the PSA, Gracemac has entered into a License Agreement with MO, (a company incorporated under the laws of Singapore and a WOS of MS Corp), on January 1, 1999 wherein Gracemac has granted MO the:

a) non-exclusive license to manufacture Microsoft products in Singapore;

b) non-exclusive license to distribute the products so manufactured to retailers or to MS Corp or to subsidiaries of MS Corp; and

c) non-exclusive right to license or sublicense the right to reproduce Microsoft software products to certain end users (large account customers) for their internal use.

In lieu of the abovementioned rights, Gracemac earns royalty from MO. The royalty was computed on the basis of the net selling price of Microsoft products manufactured by MO and distributed to retailers, MS Corp or subsidiaries of MS Corp.

4.1 In turn, MO has entered into a non-exclusive distribution and inter-company services agreement ("distribution agreement") with the Appellant, wherein Appellant was appointed as a distributor of Microsoft products manufactured by MO. Appellant was given the right to distribute Microsoft products in Asia (with restrictions in China, Korea and Taiwan), Japan, South East Asia and the South Pacific. The assessee did not have any right to copy, adapt etc. the software. The distribution agreement specifies that MO would ship the products to such addresses (of the assessee or its approved distributors) as specified by the appellant. Further, except for Australia and Japan, the title of the products has been agreed to be transferred to Appellant in Singapore which evidences the fact that delivery takes place outside India.

4.2 MO had agreed to sell the products to Appellant at a price equal to 95% of the price at which Appellant sells the product to approved distributors or other MS Corp affiliates. Pursuant to the distribution agreement, the assessee had entered into agreements with various distributors in "approved territories". The distributors had a right to distribute the products in India. The products supplied by the assessee are often stocked by distributors and then supplied against specific orders. The products were delivered by the assessee to distributors "ex warehouse" from the warehousing facility nominated by the assessee. Further, the distributor sold the products to a reseller in India who in turn sold it to a consumer/ distributor sells directly to consumers. The resellers/ consumers did not have the right to make copies of the software for "commercial exploitation". The distributor was not liable to pay the assessee only upon sale by the distributor to the reseller/ consumer. It was liable to pay the assessee even if it was not able to sell the products to the reseller/ consumer.

4.3 According to appellant the income earned from the sale of computer software to independent distributor in India was in the nature of business profit in the years under consideration and was not taxable in India as appellant did not have a PE in India under provisions of Double Taxation Avoidance Agreement between India and USA (in short DTAA). It was also contested that royalty income from sale of software could not be taxed in hand of appellant which was only distributor of the software of MS Corp and copyrights of these software were owned by MS Corp not by appellant. For these reasons it was claimed that business income of appellant was not taxable in India for the years under consideration accordingly, appellant did not file returns of income for the years under consideration. Later on, the AO issued notice to the appellant for the years under consideration u/s 148 of the Act. In response to notice appellant filed return of income declaring Nil income for the years under consideration stating above reasons for non taxability of its business profit in India. Later on, the cases of appellant for the years were selected for scrutiny by issue and service of notice U/S .143(2). During the course of scrutiny assessment the A.O assessed the income of the appellant for the years under consideration at US$ 1,01,75,235, US$ 5,87,64,099 and US$ 8,35,51,260 under the head 'Royalty' against the Nil income disclosed by the appellant in the returns of income filed for the years under consideration for following grounds:

a) The software falls under the category 'secret formula or process' and the software when installed on a computer respond to every instruction in a specific way. Accordingly, the total revenue received by the appellant from sale of software in India was royalty.

b) The appellant was taxable in India under provisions of Act and the DTAA as income from sale of software was in the nature of royalty u/s 9(1)(vi) and article 12 of DTAA.”

5. Accordingly, aforementioned income was assessed in the hands of the assessee as royalty upon which the penalty has been levied by the Assessing Officer as follows:-

Assessment Year 1999-2000 ` 6,45,31,340/-

Assessment Year 2000-2001 ` 38,30,83,161/-

Assessment Year 2001-2001 ` 58,18,92,771

6. The aforementioned additions were also upheld by learned CIT (A) against which a further appeal to the Tribunal was filed and the said appeals have been decided by the Tribunal along with the appeals in the case of M/s Gracemac Corpn. vs. Asstt. Director of Income-tax, International Tax Division, Circle 2 (1), New Delhi and appeals of M/s Microsoft Corporation vs. Asstt. Director of Income-tax vide order dated 26th October, 2010 which is since reported as 132 TTJ 257 (Del); 8 ITR (Trib.) 522 (Del); 42 SOT 550 (Del). Though it has been held by the Tribunal that the said amount was in the nature of royalty, but it was held that the said amount cannot be assessed in the hands of the present assessee and it has been held to be taxable in the hands of the Gracemac Corpn. The relevant observations of the Tribunal while holding so are contained in para 128 and 132 and it will be relevant to reproduce the said observations of the Tribunal with regard to taxability or otherwise of the aforementioned amount in the hands of the assessee:-

“128. From the above it is evident that MRSC was also authorized to reproduce certain products and distribute the same to end users through the distributors appointed by MRSC. MRSC vide agreement dated 3^rd May, 1999 was authorized to copy the marketing programmes in object code form from the master copy provided by Microsoft Operations (MO) on to either diskettes or such approved media and prepare the product documentation and packaging based on the material provided and approved by MO. We would like to mention here that source code and object code have copyright.

Therefore, MRSC also got right to use copyright in computer products from sub-licencee (MO). Each product package would include a pre-approved diskettes label attached to the diskettes and MS Corp. standard End User Licence Agreement for the territory. From the above it is evident that MRSC is not simply a distributor appointed by Microsoft Operations, but was authorized to reproduce certain computer programmes.

The End User Licence Agreement was to be in the standard format of Microsoft Corporation. Article 3.2 also provides that the marketing programme released by the distributor will be approximately equivalent in quality of the software product manufactured by MS Corp. The Microsoft Operation also provided up-dated master copies of marketing programmes as and when the same were updated by MS Corp. Since the Microsoft Corporation has granted the right to reproduce and distribute Microsoft Products in lieu of Shares to Gracemac and no further royalty is payable by Gracemac and also the End User Licence Agreement is to be in the standard format of Microsoft Corporation, the Microsoft Corp. is under obligation to sign EULA on behalf of Gracemac. Thus it has to be logically concluded that Microsoft Corporation has signed the EULA on behalf of Gracemac to whom exclusive rights to manufacture and distribute Microsoft products have been granted otherwise the products would have been rendered useless and no revenue could have been earned by anyone in the supply chain. Microsoft Corporation has devised a scheme under which EULA has to be signed by Microsoft Corp. and not by Gracemac Corporation. Hence assessee cannot be permitted to take a plea that since EULA has been signed between end users and Microsoft Corp. No licence was granted by Gracemac and consequently the royalty payments will not be chargeable to tax in the hands of Gracemac. The agreements entered into between group companies have drafted in such a way which give an impression that Gracemac Corporation has no connection with the granting of licence. The real transaction of the granting of the licence in respect of copyrights in computer programmes have camouflaged by entering into various agreements between Microsoft and Gracemac; Gracemac and Microsoft operations; Microsoft operation and MRSC; and MRSC and Indian distributors but when real intention is gathered from the in-depth reading of the agreements, the matter becomes crystal clear. Since we have held that end users have made payments in respect of the granting of licence in respect of copyright in computer programmes the payments made by endusers as consideration for the same will be taxable in the hands of Gracemac.

132. As discussed above, MRSC reproduced certain software products and distributed the same through chain of distributors in India. Therefore, the very appointment of distributors by MRSC in India, had business connection in India and the portion of income earned by MRSC perhaps could have been chargeable to tax as business income under section 9(1)(i) of the Act.

But since the assessing officer as well as the ld. CIT (Appeals) has chosen to assess the entire receipts under the head 'royalty' in the hands of MRSC also, in our considered opinion, MRSC cannot be taxed again on the same income by way of royalty for exploitation of same

rights which had been assessed in the hands of Gracemac, otherwise it would result in double taxation. Therefore, we delete the addition in the hands of MRSC for all the three years.”

7. The question involved in the quantum appeals filed by the revenue is whether learned CIT (A) is right in deleting the addition made by the Assessing Officer on account of aforementioned royalty. The learned AR of the assessee has referred to the aforementioned decision of the Tribunal wherein on similar facts, it has been held by the Tribunal that such royalty cannot be assessed in the hands of the assessee as it will tantamount to assess the same income which has been assessed in the hands of Gracemac and it has been held by the Tribunal that the aforementioned amount of royalty cannot be assessed in the hands of the assessee as the same is taxable in the hands of the Gracemac. Therefore, it is the case of the learned AR that for all the aforementioned years in which learned CIT (A) has granted relief to the assessee in quantum, will be covered by the aforementioned decision and, hence, the order of the CIT (A) for deletion of the aforementioned amount should be upheld. As against that it is the case of the learned DR that royalty has rightly been assessed in the hands of the assessee and learned CIT (A) has wrongly deleted the same.

8. In the penalty proceedings, it is the case of the learned AR that it has been held by the Tribunal that income is not assessable in the hands of the assessee. Therefore, he pleaded that there is no question of levy of concealment penalty on the assessee. He submitted that learned CIT (A) though has deleted the penalty on merits and, therefore, it is the case of the learned AR that penalty has rightly been deleted by the CIT (A) and his order should be upheld.

9. In respect of appeal filed by the assessee, it is the case of the learned AR that the facts for Assessment Year 2006-07 are same and on the basis of similar facts, ld. DRP has held that the assessee is assessable in respect of royalty. He submitted that the order of DRP is not in conformity with the decision of the Tribunal in assessee’s own case and the aforementioned decision of the Tribunal will be equally applicable for that year also and, therefore, the addition made by the department for that year should be deleted.

10. On the other hand, it is the case of the learned DR that the addition has rightly been made by the Assessing Officer and his order should be confirmed.

11. We have carefully considered the rival submissions in the light of the material placed before us. It has been held by the Tribunal in aforementioned decision that though the amount constitute royalty, but the same is not assessable in the hands of the present assessee. One of us (AM ) is party to the aforementioned decision. No case has been made out by the department to differ from the earlier decision which has been found to be delivered on the basis of similar facts. The facts for all the years are similar and this fact is not disputed by the revenue. Therefore, respectfully following the aforementioned decision of the Tribunal, the relevant observations of which has already been reproduced, we hold in the quantum appeals that the additions have rightly been deleted by learned CIT (A) and we decline to interfere in his order. Similarly, for penalty appeals, as income has not been held to be assessable in the hands of the assessee, we find no justification in levy of penalty, therefore, the order of the CIT (A) deleting the penalty is upheld on the ground that as the income itself is not assessable in the hands of the assessee according to the aforementioned order of the Tribunal, there is no question of levy of penalty.

12. So far as it relates to assessee’s appeal, the facts being similar, adopting the similar view which has been adopted by the Tribunal in earlier decision in the case of the assessee, we find no justification in assessability of aforementioned royalty in the hands of the assessee, therefore, the appeal of the assessee is allowed.

13. To sum up, in the result, all the departmental appeals are dismissed and the appeal filed by the assessee is allowed in the manner aforesaid”.

7. Respectfully following the order of the ITAT, we are of the view that though the amount constitutes royalty but the same is not assessable in the hands of the present assessee. Accordingly, the appeal of the assessee for assessment year 2007-08 is allowed partly and the appeal for assessment year 2008-09 is allowed and the additions are deleted.”

9. Respectfully following the above decision on the issue, we hold that though the amount in question constitutes royalty but the same is not assessable in the hands of the present assessee as the same has been held taxable in the hands of M/s Gracemac Corporation. The appeal of the assessee is accordingly allowed partly.

10. So far as the ground relating to initiation of penal action under Section 271(1)(c) is concerned, it is premature. Hence, it does not need adjudication. The same is rejected as such.

11. The charging of interest under Section 234B questioned by the assessee is consequential in nature. Hence, it does not need separate adjudication.

12. In the result, the appeal of the assessee is partly allowed.

Decision pronounced in the open Court on 5th July, 2013.

Sd/- Sd/-

(TARVINDER SINGH KAPOOR) (I.C.SUDHIR)

ACCOUNTANT MEMBER JUDICIAL MEMBER

Dated: 05.07.2013

VK.

Copy forwarded to: -

1. Appellant: M/s Microsoft Regional Sales Corporation, USA C/o Mr.Ashwin Ravindranath, Partner, SRBC & Associates, Golf View Corporate Tower B, Sector-42, Sector Road, Gurgaon, Haryana.

2. Respondent: Additional Director of Income-tax, International Taxation, Range-3, New Delhi.

3. CIT

4. CIT (A)

5. DR, ITAT

Assistant Registrar