Income characterisation and Microsoft

DIRECT TAX

Last week, the mail box of several tax advisers was flooded with ruling on a high-profile litigation tax matter in relation to Microsoft. The ghost of income characterisation in international transaction reared its head again as the revenue department in a significant decision sought to tax income derived by Microsoft's US parent from sale of Microsoft software to distributors in India.

An order of the Commissioner, Appeals has enhanced the assessment made by the officer and raised the demand of over $300 million.

The facts suggest that the US parent granted to another related US entity proprietary and ownership right in Intellectual property of Microsoft software and hardware as well as exclusive distribution rights for such products. The related US entity in turn granted non-exclusive right to Microsoft's Singapore entity to duplicate and market Microsoft software through Indian distributors.

For enabling the use of its software products, the US parent granted end-user license to Indian customers together with a copy of Microsoft software through its Indian distributors.

The Commissioner denying exemption on income from sale of software to end-users held that it was in the nature of 'royalty' and hence taxable in India (India follows strict source-based taxation for royalty income). The Commissioner supported his stance by arguing that payment for use of Microsoft software (which is in the nature of invention) was liable to tax as royalty and not ordinary business income. The decision, in my view, will elicit flak not just from the IT industry but also from experts who are confident that the riddle of income characterisation on off-the-shelf or boxed software was a settled issue.

Lest guns are trained against the decision, let me try and clarify the legal position on taxability of software and its characterisation between royalty and business income.

The issue on characterisation has been extensively examined by Indian judiciary. Several tribunal rulings (Delhi Tribunal in Ericsson, Nokia & Motorola; Bangalore Tribunal in Lucent Technologies, Samsung and Wipro Ltd's case) and the Supreme Court's decision in TCS' case (though rendered in the context of Sales tax, have held that consideration for use /purchase of an article incorporating a copyright (eg, sale of a packaged software) cannot be characterised as royalty since the transaction does not involve use /transfer of a right in the Copyright as such. However, consideration for use of any right in the copyright will undoubtly qualifies as royalty.

Under the OECD approach, rights in computer programs are a form of intellectual property and the characterisation of such payments depends on the nature of rights in relation to such use and exploitation.

Mere mode of delivery of software can not influence or govern categorisation of income. A simple example is sale of music "� should the character of income change depending on whether it is purchase of music CD or download of music from internet.

Consideration for acquisition of partial rights in the copyright would partake the character of royalty, if the use of copyright in absence of such rights would constitute an infringement of copyright. However, where consideration is paid for transfer of full ownership of rights in the copyright, the payment is an outright sale and hence would constitute royalty.

Is there any doubt in a situation where a customer buys a boxed software, he does not have complete ownership of rights in using such software?

The broad principle for income characterisation has been endorsed in the Report of OECD's Technical Advisory Group on Treaty Characterisation Issues arising from E-Commerce transactions. The same report was considered by the high-powered Committee constituted by the government in 1999, incidentally of which I was a member. The Revenue's reliance on the high-powered Committee's findings in the context of Microsoft is misplaced and out of context. As a matter of fact, the Committee's recommendation suggests that mode of delivery of service should not alter characterisation of income. This was in the context of sale of music. Also mentioned in the high-powered Committee report was India's need to legislate a policy (akin to Singapore's shrink wrapped software policy) to deal with such characterisation issues. Had India embarked on a similar policy, such disputes won't have arisen. Even otherwise, in absence of such policy, a narrow interpretation of law (legislated in the context of bricks and mortar business model) if unwarranted.

In summary, the decision is out of sync, besides defying well established principles of international tax and Indian judicial pronouncements. Notably, in arriving at the decision, the Revenue feigned its ignorance of Organisation for Economic Cooperation and Development (OECD) committee recommendations contending that these recommendations did not carry weight until incorporated in the law or treaties and that India is not a member of the OECD. Let's not forget that India now has a dialogue for advanced engagement (with OECD) in pursuance to moving ahead as a OECD member country. Further such observations on applicability and enforceability of OECD recommendations in Indian context is ironical, particularly in times when Indian courts are seeking reliance under OECD approach whilst adjudicating on land mark cases in international transactions (Supreme Court in IHI and Hyundai to name a few).

Although, the Commissioner has placed reliance on landmark international rulings on tax treatment of software licensing, unfortunately, it lost sight of well entrenched principles emanating from judicial pronouncements in India.

Given the quantum of tax involved and the basic tenet of taxing software income being called in question there is no doubt the case would be sub-judice for months and years to come. Finally, the Microsoft case will progress under the normal administrative appeal process, and hence would be long drawn affair. I hope that the policy makers and legislature intervene to clarify the law. An opportunity to improve India's tax competitiveness will otherwise be lost!

(The author is a Partner with BMR Advisors and was member of high-powered Committee on E-Commerce taxation. Views expressed herein are personal)