Software companies are facing a potential aggregate tax liability of over $1 billion (R5,000 crore) with the Karnataka High Court ruling that payments made to overseas software suppliers are taxable.

The ruling follows a long-drawn dispute between software companies and the income tax department. The court ruled that payments for software imports would qualify as royalty, for which the importer must deduct tax at source ? widely known as ?withholding tax?.

The ruling, announced last Saturday, will adversely impact all technology firms importing software. N Venkatraman, head of strategic finance and risk management, Sonata Software, told FE: ?The high court has held that payments for software imports qualified as royalty because they believe there is use of copyright,? adding that tax demands will start piling up soon.

He qualified that since Sonata?s foreign partner has paid substantial taxes, the net demand would be ?very little. Still, in principal, we will have to fight it out. Net of payments, the claims would be about R3-5 crore for us?.

The judgment opens up a new avenue for tax authorities to tap the country?s huge IT sector and will raise the cost of doing international software transactions for technology firms, experts warned.

Abhishek Goenka, partner at tax and regulatory advisory BMR Advisors, said: ?It will make any software transaction with Indian companies liable to withholding tax. In most cases, the foreign principals don?t get the credit of Indian withholding tax and, therefore, it will increase the cost of doing software transactions?.

Software firms have all along held that TDS should not be deducted while remitting payments overseas as they do not deem the income to be taxable in India. But direct tax authorities have argued that the moment a payment is made to a non- resident, there is an obligation on the payer to deduct tax under Section 195 (1) of the Income Tax Act.

An executive from a tax advisory quoted an estimate to say that aggregate claims from the I-T department on all software companies could add up to a billion dollars. The ruling, he added, could make revenue authorities aggressively pursue scrutiny of tax withholding. The I-T department is looking to recover dues from the year 2000. Tax consultants point out that most of the affected companies will file appeals or special leave petitions before the Supreme Court against the order.

Goenka added that both distributors of software and OEMs would be affected. ?Companies engaged in the distribution of software and those who buy software for their own use will be affected. However, the dimension of the issue is much larger if you are a distributor because that is your business?.

CA Gupta, partner, direct tax, Deloitte, Haskins and Sells, said the ruling could have three implications. ?First, tax authorities will want to recover both tax and interest from software companies. Second, there may be a penalty ? tax authorities have discretion to levy it. Third, if companies have not deducted tax on royalty payments, they will not be eligible to claim a deduction of the expenditure,? he noted.

The Karnataka High Court had earlier decided that all payments to non-residents were liable to withholding taxes. Software companies moved the Supreme Court and in September last year, which gave them a breather. SC had held that it is only in respect of those payments which are ?chargeable to tax? in India that tax withholding would be applicable. The SC, however, did not specify whether payments for import of software are chargeable to tax in India and sent the matter back to the high court. On Saturday, a division bench of the Karnataka high court headed by Justice VG Sabhahit noted that payments for software imports qualified as royalty and thereby requires a tax withholding.