Coding in tax certainty

By: |
March 11, 2021 6:20 AM

The SC ruling on taxation of overseas software brings welcome relief to the taxpayer. However, there are certain questions that require deliberation

After two decades of wait, this ruling brings much-needed certainty on characterisation of software transactions, especially for non-resident taxpayers facing the ire of the retrospective amendments, with Supreme Court reinforcing the supremacy of treaty protection.After two decades of wait, this ruling brings much-needed certainty on characterisation of software transactions, especially for non-resident taxpayers facing the ire of the retrospective amendments, with Supreme Court reinforcing the supremacy of treaty protection.

The Supreme Court has ruled that payments by Indian end-users or distributors of overseas software can’t be considered taxable as ‘royalty’, under tax-treaties containing the definition on the lines of the OECD Model Convention. The SC has followed the globally-accepted interpretation—payment made by end-users and distributors is akin to payment for sale of goods and is not for grant of licence under the Indian Copyright Act. Only where copyright in the software is permitted to be exploited by the payer can the payment take the character of royalty and be subject to tax, per tax-treaties.

This ruling should now prevent similar disputes, but a few questions still require deliberation.

Both Indian payers (importers) and non-resident sellers must evaluate the impact of the ruling on pending disputes. Given the underlying issue has now been put to rest, the taxpayers will be looking to obtain refunds of taxes paid against demands raised or taxes paid by way of withholding tax deposited. In cases where this aspect hasn’t been disputed in the past, fresh claims for refunds will have to be lodged either by the non-resident payee or resident payer depending on the type of contracts, i.e. net of tax or grossed-up. In case of net-of-tax contracts, it will be the non-resident payee who will be eligible, whereas in case of grossed-up contracts, Indian payers can also seek refunds under the relevant law. In case of net-of-tax contracts, where payers may seek refunds, the refunds will then have to be remitted to non-resident payees. Thus, review of the contracts for software supplies is necessary to determine eligibility for refunds and lodge claims. For refund claims barred by the statute of limitations, taxpayers may need to approach the Central Board of Direct Taxes for directions for grant of refund.

Another impact is on the foreign tax credits (FTC) claimed by non-resident sellers in their home-country against the taxes paid or withheld in India. Such non-residents will have to ascertain the right quantum of FTC credit claimed in their home-country and evaluate the risk of reversal or reduction of claim.

There are many resident payers who adopted a non-taxability position at the withholding stage, but given the stand of the taxman to the contrary, demands were raised/tax recovered from the purported failure to withhold tax at source. In such cases, the payers may have recovered back-taxes from the non-resident payees, invoking tax indemnification clauses under the contract. Such non-resident payees may now seek a refund from the payers.

The SC has also said that the definition of ‘royalty’ under the domestic law—clarified by way of a retrospective amendment made by Finance Act, 2012—can’t be relied upon to fasten withhold tax obligation on the payers, given the clarification wasn’t in effect on the date of payment. This observation will have an impact on situations wherein the payers have been fastened with obligations to withhold taxes due to retrospective amendment in the tax-laws.

The decision favours the taxpayers, but all is not lost for the taxman. The new equalisation levy (EL) regime seeks to cover online sale of goods and services by an overseas e-commerce operator, which will ensure tax collection of 2% on gross incomes where software supplies are transacted through digital platforms. Thus, foreign firms will have to revaluate the applicability of EL on software transactions that are now clearly out of the royalty net. It may also be relevant to evaluate if the sales model for software gives rise to a ‘permanent establishment (PE)’ in India that may bring back tax incidence on such software revenues as business profits attributable to the PE.

After two decades of wait, this ruling brings much-needed certainty on characterisation of software transactions, especially for non-resident taxpayers facing the ire of the retrospective amendments, with Supreme Court reinforcing the supremacy of treaty protection. The rationale laid down by the apex court will be relevant for all pending cross-border tax disputes; however, the non-resident taxpayers will have to ensure that they meet the eligibility for treaty entitlement such as beneficial ownership and evidence of a valid tax residency.

Given the stakes involved, it is certain that the government treasury has to pay a few hundred crore in refunds. The ruling, however, provides much-needed certainty in interpreting tax laws applicable to cross-border transactions and reassuring taxpayers.

The author is Tax leader (technology, media & entertainment, and telecommunications), EY India
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