TDS applicability for Payments made to foreign software suppliers for purchase of software

The Supreme Court of India in the case of Engineering Analysis Centre of Excellence Pvt. Ltd. vs. CIT ([2021] 432 ITR 471 SC) delivered a landmark judgment regarding the taxation of software license payments made to foreign companies. This decision clarified whether such payments are to be treated as royalty under the Income Tax Act, 1961 and whether they are subject to TDS under Section 195.

Here is a detailed explanation of the judgment and its implications:

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Facts of the Case

1. Indian companies purchased software licenses from foreign suppliers, such as:
   • Foreign software developers or vendors.
   • Distributors or resellers of software.
2. The Indian Revenue Authorities treated these payments as royalty, invoking Section 9(1)(vi) of the Income Tax Act, 1961.
3. The tax department demanded TDS deduction under Section 195 on such payments.
4. The taxpayers argued that the payments were not for the use of copyright but for the use of a copyrighted product (software), and hence they did not qualify as royalty.

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Key Issue before the Supreme Court

• Whether payments made to foreign software suppliers for purchase of software or software licenses constitute “royalty” under the Income Tax Act and DTAA?

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Supreme Court’s Judgment

The Supreme Court ruled in favor of the taxpayers and held that:

1. No Royalty for Use of Copyrighted Product:
   • Payments made to purchase software licenses are not in the nature of royalty if the buyer gets only a non-exclusive and non-transferable license to use the software.
   • This does not grant the buyer any rights over the copyright of the software.
   Example: When a person purchases a software license (e.g., Microsoft Office), they receive the right to use the software but not the right to reproduce, distribute, or modify the software.
2. Applicability of DTAA:
   • The definition of “royalty” in the India-USA DTAA or other applicable DTAAs must prevail if it is more beneficial to the taxpayer.
   • The DTAA stipulates that for a payment to be treated as royalty, there must be a grant of rights in the copyright (not just the right to use the copyrighted software).
3. No TDS Deduction under Section 195:
   • Since the payments are not royalty, there is no obligation to deduct TDS under Section 195.
   • Payments to foreign companies for software licenses are, therefore, not taxable in India if there is no Permanent Establishment (PE) in India.

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Key Observations by the Court

• Distinction between:
  1. Copyright: A legal right to reproduce, distribute, or modify software.
  2. Copyrighted Article: A product or license that allows the end-user to use the software without ownership of the copyright.
• The Court emphasized the principles of OECD Commentary on Model Tax Convention and clarified that the use of software as a product is different from the use of the underlying copyright.
• The Court also relied on earlier High Court decisions, such as the Dassault Systemes and Samsung Electronics cases, but ultimately settled the law in favor of taxpayers.

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Implications of the Judgment

1. No Royalty Treatment:
   • Payments for software licenses are not royalty unless there is a transfer of copyright rights (e.g., rights to reproduce or distribute).
2. TDS Not Required:
   • Indian entities are not required to deduct TDS under Section 195 on payments for off-the-shelf software or software licenses from foreign vendors.
3. Clarity for DTAA Transactions:
   • The beneficial provisions of India-USA DTAA or other treaties will prevail, providing relief to taxpayers.
4. Scope of Section 9(1)(vi):
   • The retrospective amendment to Section 9(1)(vi) of the Income Tax Act cannot override the DTAA provisions, as clarified in earlier cases and reaffirmed by the Supreme Court.

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Conclusion

The Engineering Analysis case establishes that payments made for software licenses or for the purchase of software do not constitute royalty and are not subject to TDS under Section 195, provided:

• The foreign supplier does not have a Permanent Establishment (PE) in India.
• The payment is merely for the use of software as a product (not for rights in the copyright).

This judgment has provided significant relief to taxpayers and resolved long-standing disputes regarding the characterization and taxation of software payments.