Revaluation of Capital Asset Made Liable to Capital Gains Tax

In the case of The Commissioner of Income Tax v. M/s Manuskh Dyeing and and Printing Mills (Partnership Firm) [Civil Appeal No. 8258 & 8259 of 2022], the Supreme Court panel comprising of Justice M.R. Shah and M.M. Sundresh ruled that Section 45(4) of the Income Tax Act applied where there was an increase in partners’ capital account on account of revaluation of asset (land & building).

The bench stated that the partners had access to the money in order to withdraw it. The assets so revalued and the credit made to the capital accounts of the individual partners were therefore a “transfer” and came under the category of “OTHERWISE.” As a result, Section 45(4)’s provision was applicable.

Background

The assessee a partnership firm constituted with four related individuals were engaged in the business of Dyeing and Printing, Processing, Manufacturing and Trading under the following profit-sharing structure.
Share of Profit
For ease of reference, herewith Partners are referred as A, B, C, D:

Phase 1

Execution of Family Settlement Deed dated 02/05/1991; the share of one of the existing partners (Mr. D) was reduced and distributed among new incoming partners (Let’s say E, F & G):
Partners and Share of Profit (Post Settlement)
 

Phase 2

Reconstitution of Partnership Firm; Partner B, C & D retired from the Firm:
Partnership structure (Post Retirement)
   

Phase 3

The Firm was again reconstituted on 01/11/1992; 4 new partners were added.
Partnership structure and contribution by new partners (Post Reconstruction)
In the reconstituted partnership deed two partners, namely, A and E decided to withdraw part of their capital.

Phase 4

The assessee revalued the asset (Land & Building) for an amount of Rs.17.34 crores against which the capital account of H, I, J & K was revised:  
Particulars H I J K
Initial Capital Contribution 4.5 Lac 2.5 Lac 2.25 Lac 2.25 Lac
Revised Capital Account 3.12 Cr 1.73 Cr 1.56 Cr 1.56 Cr

Facts of the Case

  1. The Return of Income was filed for Assessment Year “AY”1993-1994 declaring total income of Rs. 3,18,760/-. The same was accepted under Section 143(1) of the Income Tax Act, 1961(hereinafter referred to as the Act).
  2. However, thereafter, the assessment was reopened under Section 147 of the Act by issuance of the notice under Section 148 of the Act. The assessment was reassessed under Section 143(3) read with Section 147 of the Act determining the total income of Rs.2,55,19,490/
  3. Addition of Rs.17.34 Cr. was made towards short term capital gain under Section 45(4) of the Act. Similar addition was made for A.Y. 1994-1995.
  4. As per the Assessing Officer., the assessee revalued the land and building and enhanced the valuation from Rs.21,13,225/- to Rs. 17,56,00,000/- for AY 1993-1994 thereby increasing the value of the assets by Rs.17,34,86,772/- and therefore the revaluing of the assets, and subsequently crediting it to the respective partners’ capital accounts constitutes transfer, which was liable to capital gains tax under Section 45(4) of the Act.
  5. As land and building was involved, the assessee had claimed the depreciation on building, and the Assessing Officer assessed the amount of short-term capital gain under Section 50 of the Act.
  6. The CIT(A) confirmed the addition made by the Assessing Officer. However, ITAT allowed the appeal and has set aside the addition made by the A.O. towards Short Term Capital Gains by observing that revaluation of the assets and crediting to partners’ account did not involve any transfer.
  7. The High court dismissed the appeal preferred by the Revenue. Thus, the revenue approached the supreme court.

Question Before the Apex Court

Whether increase in partners’ capital account on account of revaluation of asset (land & building) would fall under section 45(4) of the Act as introduced by the Finance Act, 1987?

Ruling

  1. At the outset, the Apex Court stated that, the object and purpose of introduction of Section 45(4) of the Act was to pluck the loophole by insertion of Section 45(4) and omission of Section 2(47)(ii) of the Act. Earlier, omission of Clause (ii) of Section 2(47) and Section 47(ii) exempted the transform by way of distribution of capital assets from the ambit of the definition of “transfer”. The same helped the assessee in avoiding the levy of capital gains tax by revaluing the assets and then transferring and distributing the same at the time of dissolution. The said loophole came to be plucked by insertion of Section 45(4) and omission of Section 2(47)(ii). At this stage, it is required to be noted that the word used “OR OTHERWISE” in Section 45(4) is very important.
  2. In the present case, the assessee relied upon the decision of Bombay High Court in case of Commissioner of Income Tax, West Bengal Vs. Hind Construction Ltd., (1972) 4 SCC 460 wherein it was stated that “unless there is a dissolution of partnership firm and thereby the transfer of the amount on revaluation to the capital accounts of the respective partners, Section 45(4) of the Income Tax shall not be applicable.” However, the Apex Court stated that, in view of the amended Section 45(4) of the Income Tax Act inserted vide Finance Act, 1987, by which, “OR OTHERWISE” is specifically added, the aforesaid case has no substance.
  3. The CIT(A) relied on the decision of Bombay High Court in case of Commissioner of Income Tax Vs. A.N. Naik Associates and Ors., (2004) 265 ITR 346 (Bom.) wherein the Court had “an occasion to elaborately consider the word “OTHERWISE” used in Section 45(4). After detailed analysis of Section 45(4), it is observed and held that the word “OTHERWISE” used in Section 45(4) takes into its sweep not only the cases of dissolution but also cases of subsisting partners of a partnership, transferring the assets in favour of a retiring partner.”
  4. Under the circumstances, for the purpose of interpretation of newly inserted Section 45(4) to the Act, the decision of this Court in the case of Hind Construction Ltd. (supra) shall not be applicable and/or the same shall not be of any assistance to the assessee. As such, we are in complete agreement with the view taken by the Bombay High Court in the case of A.N. Naik Associates and Ors., (supra). We affirm the view taken by the Bombay High Court in the above decision.
  5. In the present case, the Apex Court held that the assets of the partnership firm were revalued to increase the value by an amount of Rs. 17.34 crores on 01.01.1993 (relevant to A.Y. 1993-1994) and the revalued amount was credited to the accounts of the partners in their profit-sharing ratio and the credit of the assets’ revaluation amount to the capital accounts of the partners can be said to be in effect distribution of the assets valued at Rs. 17.34 crores to the partners and that during the years, some new partners came to be inducted by introduction of small amounts of capital ranging between Rs. 2.5 to 4.5 lakhs and the said newly inducted partners had huge credits to their capital accounts immediately after joining the partnership, which amount was available to the partners for withdrawal and in fact some of the partners withdrew the amount credited in their capital accounts.
Therefore, the assets so revalued and the credit into the capital accounts of the respective partners can be said to be “transfer” and which fall in the category of “OTHERWISE” and therefore, the provision of Section 45(4) inserted by Finance Act, 1987 w.e.f. 01.04.1988 shall be applicable.  

Held

In view of the above and for the reasons stated above, the impugned judgment and order passed by the High Court and that of the ITAT were held unsustainable and were quashed and set aside with the original order being restored. Present appeals were accordingly allowed with no cost.

FM Comments

The Supreme Court decision clarifies the interpretation of the provisions of section 45(4) of the Act and holds that the revaluation of capital asset and consequent credit into the capital accounts of the respective partners would be chargeable to tax as capital gains. The Judgement will impact the Real Estate Industry and others who had taken the benefit of these provisions as a tax planning strategy.

The bench stated that the partners had access to the money in order to withdraw it. The assets so revalued and the credit made to the capital accounts of the individual partners were therefore a “transfer” and came under the category of “OTHERWISE.” As a result, Section 45(4)’s provision was applicable.

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Tax Withholding under Section 194R: CBDT Issues Additional Guidelines

The CBDT has, vide Circular No. 18 of 2022, dated September 13, 2022, aimed to remove difficulties on the implementation of TDS on benefits or perquisites under Section 194R of the Income Tax Act of 1961 “Act”). This circular is a continuation of Circular No. 12, issued by CDBT earlier, on June 16, 2022, providing guidelines on the scope and coverage of Section 194R of the Act. The Income Tax Department explicitly makes it clear that this Circular is only for the removal of difficulties in the implementation of provisions of Section 194R of the Act and does not impact the taxability of income in the hands of the recipient, which shall be governed by the relevant provisions of the Act.

Key Clarifications in Circular No. 18 of 2022

 

One-time loan settlement/waiver of loan

The provision of Section 194R of the Act shall not be applicable on one-time loan settlements entered with or waivers of loans granted to borrowers by specified banks or financial institutions.

 

Reimbursement of expenses incurred by a ‘Pure Agent’

Any expense incurred by a “pure agent,” as defined under the GST Valuation Rules, 2017 and which is in turn reimbursed by the service recipient, would not be treated as a benefit or perquisite for the purposes of Section 194R, and therefore the pure agent would not be liable to deduct TDS u/s 194R of the Act. It has been explained that in such cases, even the GST input credit ought to be availed of by the service provider and not the service recipient.

 

Interplay of 194R and other TDS provisions

The Circular clarifies that if reimbursement of out-of-pocket expenses (OPE) is already a part of the gross consideration and tax has been deducted on the gross consideration under sections 194J or 194C of the Act, then there would not be any further liability to deduct tax under section 194R of the Act.

 

Expenditure incurred on dealers’/business conferences

In case of a dealers’ conference to educate the dealers about the company’s products, it has been clarified that:

  • It is not necessary to invite all dealers to a conference for the expenses incurred for conducting the conference to not be reckoned as a benefit or perquisite for tax deduction.
  • Any overstay by a dealer beyond one day prior and one day after the date of the conference would be treated as a benefit or perquisite liable for deduction of tax under Section 194R.
  • Where it is not possible, owing to practical difficulties, to ascertain the actual number of dealers for whom certain expenses were incurred, which should be classified as a benefit/perquisite, then to avoid any further challenges, the taxpayer who has provided the benefit/perquisite may suo-moto disallow the said expenditure, and thereafter, there will not be any requirement to comply with the provisions of Section 194R.

 

Availability of depreciation on any capital asset (car) gifted as a benefit/perquisite

Where any capital asset is received as a gift and tax has been withheld under Section 194R, the recipient shall be eligible to claim depreciation under Section 32 of the Act on such asset. The Circular clarifies that the value of such a benefit/perquisite offered as ‘income’ in the income-tax return of the recipient shall be deemed to be ‘actual cost’ in the hands of the recipient for the purpose of calculating such depreciation.

 

Liability on Embassy or High Commissions

The Circular clarifies that certain embassies and high commissions are not required to deduct tax under Section 194R of the Act for the benefit/perquisite provided by such organisations.

 

Liability on issuance of bonus/right shares

Tax under Section 194R of the Act is not required to be deducted on the issuance of bonus or right shares issued by a company in which the public is substantially interested ( a listed company), as the overall value and ownership of their holding remain the same.

 

Practical Application

The above additional guidelines are welcome clarifications, as they certainly provide much needed clarity and certainty to some of the issues and concerns that were raised through representations by various industry and professional forums. As such, it is expected that the vexed provisions of Section 194R of the Act would now be less cumbersome in their practical application. Needless to say, there are still several issues in Section 194R and its application, which continue to bother the assessees regularly. It is hoped that CBDT, in the coming days, will continue with its avowed objective of making tax administration simple and provide further clarity on the other issues and challenges.

The Income Tax Department explicitly makes it clear that this Circular is only for the removal of difficulties in the implementation of provisions of Section 194R of the Act and does not impact the taxability of income in the hands of the recipient, which shall be governed by the relevant provisions of the Act.

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Faceless Appeal Scheme 2021: A Forward-Looking Initiative

The Central Board of Direct taxes (“CBDT”), with an objective of bringing in more transparency in the appeal proceedings and “honoring the honest”, had introduced the “Faceless Appeal Scheme 2020”[1] (“Old Scheme”), on September 25, 2020. The Old Scheme was introduced with an aim to eliminate human interference between the taxpayer and the First appellate authority (Commissioner Appeals), thereby ensuring that the appeals are disposed in a fair manner and are not influenced by any relation and human biasness.

The Old Scheme was introduced with the noble intention of curbing malpractices, easing compliance and make appeal process seamless and faceless. However, there were some post implementation hiccups experienced and accordingly taxpayers requested certain modifications in the Old Scheme.

In order to fix the hiccups and incorporate the changes requested by taxpayers, the CDBT, in supersession of the Old Scheme, has introduced a new appeal scheme called as “Faceless Appeal Scheme 2021”[2] (“New Scheme”) on December 28, 2021.

In this alert, we have made an effort to apprise the readers with the changes introduced in the New faceless appeal Scheme vis-à-vis the Old Scheme.

Key Changes in the New Faceless Appeal Scheme, 2021

The key changes brought in by the New Appeal Scheme are as follows:

  1. Mandatory personal hearing, if requested

In the Old Scheme, the appellant or his authorized representative had to make a request for personal hearing and the Chief Commissioner or Director General in charge of the Regional Faceless Appeal Centre (RFAC) had the discretion to approve such request, if he was of the opinion that the request is covered by the circumstances laid down by the CBDT.

In the New Scheme, there is no requirement for prescribed circumstances and the discretion for grant of personal hearing has been completely removed. CIT(A) shall allow personal hearing if requested by the appellant anytime during the course of the proceedings.

  1. Restructuring of the appeal center

In the Old Scheme, CBDT had set up a three-layer structure with National Faceless Appeal Centre (NFAC) at the top to conduct appeals in a centralized manner (nodal agency), followed by RFAC to support NFAC and Appeal Unit (AU) at the bottom, to facilitate the conduct of e-appeal proceedings and dispose them. In the composition structure, each AU unit had one or more Commissioner Appeals [CIT(A)].

In comparison, the New Scheme has done away with the RFAC and has set up a two-layered structure headed by NFAC and AU will directly coordinate with NFAC and conduct the appeal and dispose them. Further, in the New Scheme, each AU will have only one CIT(A).

  1. Elimination of review by multiple AUs

In the Old Scheme, the NFAC on receipt of draft order from AU, would  review the order and if the payable amount in respect of disputed issue was more than a specified amount, then send the draft order to another AU, other than the AU which had prepared it. In any other case, the NFAC would  examine the order based on the specified risk management strategy and then finalise the appeal or send the draft order to another AU.

The other AU who was assigned such case, would  either concur with the order or suggest variations as it would  deem fit. In case of variation, the NFAC would  assign the said appeal to another AU other than the one who had prepared or reviewed the draft order. The NFAC would then pass the final order, based on the order received from the last AU.

In the New Scheme, the CIT(A), after examining the submissions, shall now pass the order by digitally signing the same and send it to NFAC, along with details of penalty proceedings, if any, to be initiated therein.

Such order shall be final and will not be reviewed at multiple AUs as provided in the erstwhile scheme. NFAC shall communicate such order to the appellant and such other officers as may be prescribed.

  1. Penalty Proceedings

In the Old Scheme, AU in the event of any non-compliance during the appeal proceedings, had to send a recommendation to NFAC to initiate penalty proceedings. However, in the New Scheme, there is no need to send such recommendation and the CIT(A) can directly send the penalty notice through NFAC.

FM Comments:

The modifications provided in the New Scheme are certainly a move in the right direction by easing the process and building a robust appeal scheme. The CDBT, by removing the discretionary power of the authorities for grant of personal hearing, has also made an effort to meet the constitutional validity criteria, which has also been one of the matters, challenged before the Courts.

References: 

[1] Notification No 76/2020 dated 25 September 2020

[2] Notification No 139/2021 dated 28 December 2021

Image Credits: Photo by Arina Krasnikova from Pexels

In order to fix the hiccups and incorporate the changes requested by taxpayers, the CDBT, in supersession of the Old Scheme, has introduced a new appeal scheme called as “Faceless Appeal Scheme 2021”[2] (“New Scheme”) on December 28, 2021.

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SC: Consideration Paid for Purchase of Computer Software, Not Royalty, No Obligation on Buyers to Deduct Tax at Source

IN BRIEF:

The Hon’ble Supreme Court of India (SC) has at long last, put to rest the two-decade old controversy in relation to taxability of the consideration paid for purchase of computer software from a non-resident distributor/ manufacturer. The controversy revolved around whether the consideration paid for purchase of the computer software would constitute ‘Royalty’ as per the provisions of section 9(1)(vi) of the Act, read with relevant Double Taxation Avoidance Agreement (‘DTAA’). There were divergent views of some High Courts as well as of the Authority for Advance Rulings on this issue, which, thankfully, has now been settled by the Hon’ble SC, against the Revenue and in favour of the taxpayers.

In the case of Engineering Analysis Centre of Excellence Private Limited1 and others (Appellants), the Hon’ble SC has held that the consideration paid for purchase of an off-the- shelf software from a non-resident seller does not tantamount to ‘Royalty’ as per Article 12 of the DTAA and hence there is no obligation on the Indian buyer to deduct tax at source under section 195 of the Income-tax Act, 1961 (‘the Act’), as the distribution agreements/ End-User Licence Agreements (EULAs) do not create any interest or right in such distributors/ end-users which would tantamount to the use of or right to use any copyright.

FACTS OF THE CASE:

The Appellants had imported/ acquired shrink wrapped computer software from non-residents distributor/ manufacturers. While making payment to those non-residents, the Appellants did not deduct tax at source under section 195 of the Act, on the premise that such amounts do not constitute ‘Royalty’; hence are not taxable in India as per the relevant DTAA and accordingly, there could not be any obligation on them to deduct tax at source under section 195 of the Act.

QUESTION BEFORE THE SC:

The key question before the Hon’ble SC was whether there would be any obligation on a resident buyer, acquiring computer software from a non-resident distributor/ manufacturer, to deduct tax at source, under section 195 of the Act, by classifying the consideration paid as ‘Royalty’ under section 9(1)(vi) of the Act, read with Article 12 of the relevant DTAA.

There were various appeals/ questions raised before the Hon’ble SC, which were grouped into four categories:

a) Computer software purchased directly by resident end-users from non-resident suppliers or manufacturers.
b) Resident distributors or resellers purchasing computer software from non-resident suppliers or manufacturers and then reselling the same to resident Indian end-users.
c) Non-resident distributors reselling the computer software to resident Indian distributors or end-users.
d) Computer software embedded into hardware and sold as an integrated unit/equipment by non-resident suppliers to resident Indian distributors or end-users.

APPELLANT’S CONTENTIONS:

The Appellant’s contentions have been summarized below:

  •  Computer software that is imported for onward sale constitutes ‘Goods’.
  • Definition of Royalty as per DTAA did not extend to a derivative product of the copyright. For example, a book or a music CD or software products.
  • Retrospective amendment to section 9(1)(vi) by Finance Act 2012 could not be applied to assessment years under consideration, as the law cannot compel one to do the impossible.
  • Provisions of DTAA would prevail over the provisions of the Act to the extent they are more beneficial to the deductor of tax under section 195 of the Act.
  • Distinguishment can be made between the sale of a copyrighted article v/s. the sale of copyright itself. As per section 14(b) of the Copyright Act, 1957 Act (“CA Act”), ‘Computer Program’ and a ‘copy of Computer Program’ are two distinct subject matters. In the instant case, no copyright was transferred, as the end-user only received a limited license to use the product by itself with no right to reproduce, sub-licence, lease, make copies, etc.
  • It was also contended that explanation 4 to section 9(1)(vi) of the Act would apply only to section 9(1)(vi)(b) of the Act and would not expand the definition of Royalty as contained in explanation 2 to section 9(1)(vi) of the Act. Further, reference was made to Circular No. 10/2002 issued by Central Board of Direct Taxes (CBDT), wherein, ‘remittance for royalties’ and ‘supply for computer software’ were addressed as separate distinct payments, the former attracting the ‘royalty’ provision and the latter taxable as business profits.
  • Based on the doctrine of first sale/ principle of exhaustion, it was argued that the foreign supplier’s distribution rights would not extend to sale of copies of the work to other persons beyond the first sale.

REVENUE’S CONTENTION:

The Revenue’s contentions have been summarized below:

  • The primary contention of the Revenue was that what was transferred in the transaction between the parties was copyright and accordingly the payment would constitute Royalty and Indian user/ importer would be required to deduct tax at source.
  • It was argued that explanation 2(v) to section 9(1)(vi) of the Act applies to payments to a non-resident by way of royalty for the use of or the right to use any copyright. Reliance was placed on the language of explanation 2(v) and it was stressed that the words “in respect of” have to be given a wide meaning.
  • The Revenue further contended that since adaptation of software could be made, albeit for installation and use on a particular computer, copyright was parted with by the original owner.
  • It was further pointed out that the Indian Government has expressed its reservations on the OECD Commentary dealing with the parting of copyright and royalty.
  • It was argued that in some of the EULAs, it was clearly stated that what was licensed to the distributor/end-user by the non-resident would not amount to a sale, thereby making it clear that what was transferred was not goods.
  • It was further argued that explanation 4 of section 9(1)(vi) of the Act existed with retrospective effect from 1976 and accordingly the Appellants ought to have deducted the tax at source even prior to the year 2012.
  • The Revenue placed reliance on the ruling of PILCOM v. CIT, West Bengal- VII, 2020 SCC Online SC 426 [“PILCOM”]2, which dealt with section 194E of the Act, for the proposition that tax has to be deducted at source irrespective of whether tax is otherwise payable by the non-resident assessee.
  • With respect to the doctrine of first sale/principle of exhaustion, it was argued that it would have no application since it is not statutorily recognised in section 14(b)(ii) of the CA Act. Accordingly, it was contended that when distributors of copyrighted software ‘license’ or ‘sell’ such computer software to end-users, there would be a parting of a right or interest in copyright; in as much as, such “license” or sale would be hit by section 14(b)(ii) of the CA Act.

THE RULING:

  • Provisions of CA Act

The Hon’ble SC placed reliance on the provisions of the CA Act and observed as under:

The expression ‘copyright’ means the “exclusive right” to do or authorise the doing of certain acts “in respect of a work”. In the case of a computer program, section 14(b) read with section 14(a) of the CA Act prescribes certain acts as to how the exclusive rights with the owner of the copyright may be parted with. Thus, the nature of rights prescribed under section 14(a) and section 14(b) of the CA Act would be referred to as “copyright”, which would include the right to reproduce the work in any material form, issue copies of the work to the public, perform the work in public, or make translations or adaptations of the work.

Section 16 of the CA Act states that no person shall be entitled to copyright otherwise than under the provisions of the CA Act or any other law for the time being in force. Accordingly, it is held that the expression ‘copyright’ has to be understood only as is stated in section 14 of the CA Act.

On perusal of the distribution agreements, the Hon’ble SC observed that what is granted to the distributor is only a non-exclusive, non-transferable licence to resell computer software and it was expressly stipulated that no copyright and no right to reproduce the computer program, in any manner, is transferred either to the distributor or to the ultimate end user.

It further observed that the ‘license’ that is granted under EULA, conferring no proprietary interest on the licensee, is not a licence that transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the CA Act. The SC held that there must be a transfer by way of license or otherwise, of all or any rights mentioned in section 14(b) read with section 14(a) of the CA Act.

  • Sale of Goods

The SC further observed that what is ‘licenced’ by the non-resident supplier/ distributor is in fact a sale of a physical object, which contains an embedded computer program and thereby held the same as “sale of goods” by placing reliance on the ruling of Hon’ble SC in the case of Tata Consultancy Services v. State of A.P., 2005 (1) SCC 308.3

  • Royalty in the DTAA vs the Act

It was observed that DTAA provides an exhaustive definition of ‘Royalty’ as it uses the expression “means” whereas the definition of ‘Royalty’ contained in the Act is wider in nature. Accordingly, Article 12 of the DTAA defining the term ‘Royalty’ would be relevant to determine taxability under DTAA, as it is more beneficial to the assessee as compared to section 9(1)(vi) of the Act.

It was further observed that explanation 4 to section 9(1)(vi) of the Act (retrospectively introduced vide Finance Act, 2012) is not clarificatory of the position as of 1 June 1976, but it expands the existing position and hence it does not clarify the legal position as it always stood.

The SC relied on two legal maxims, lex non-cogit ad impossibilia, i.e., the law does not demand the impossible and impotentia excusat legem, i.e., when there is a disability that makes it impossible to obey the law and further relied on various judicial precedents and held that any ‘person’ cannot be expected to do the impossible and accordingly the expanded definition of Royalty inserted by explanation 4 to section 9(1)(vi) of the Act cannot apply retrospectively, as such explanation was not actually and factually in the statute.

  • PILCOM Ruling

It was observed that the PICLOM ruling was in respect of section194E of the Act which deals with a different set of TDS provisions, without any reference to chargeability to tax under the Act. As already held in GE Technology4, deduction of tax under section 195 can be made only if the non-resident assessee is liable to pay tax under the provisions of the Act and accordingly it had no application to the present facts of the case.

  • Doctrine of First Sale/ Principle of Exhaustion

The SC relied on various judicial precedents to explain the concept of the doctrine of first sale/ principal of exhaustion, which enables free trade in material objects on which copies of protected works have been fixed and put into circulation, with the right holder’s consent. The said principle was introduced in the CA Act, vide amendment made in the year 1999.

Based on the above principle, it is held that the distribution rights subsist with the owner of the copyright, to the extent such copies are not already in circulation. Thus, it is the exclusive right of the owner to sell or to give on commercial rental or offer for sale or for commercial rental, ‘any copy of computer program’. The distributor who resells the computer program to the end-user cannot fall within its scope.

  • Interpretation of treaties and OECD Commentary

India has reserved its right under the OECD Commentary with respect to taxation of royalties and fees for technical services. However, in this regard, the SC has noted that, after India took such positions, no bilateral amendment was made by India and the other Contracting States to change the definition of royalties. Accordingly, the OECD commentary would only have persuasive value with respect to the interpretation of the term ‘Royalties.

  • CBDT Circular No. 10/2202 dated 9 October 2002

The SC further referred to the above-mentioned Circular, wherein the Revenue itself has made a distinction between royalties and remittance for the supply of computer software (which is treated as business profits and taxability depends upon the existence of permanent establishment in India).

  • Ruling

In light of the aforementioned reasoning, the Hon’ble SC held that the consideration paid for the purchase of an ‘off-the-shelf’ software from a non-resident seller did not amount to ‘Royalty’ as per Article 12 of DTAA, as the distribution agreements/ EULAs did not create any interest or right in such distributors/ end-users, which tantamounted to the use of or right to use any copyright. Since the amount was not chargeable to tax in India, there was no obligation on the Indian resident buyer to deduct tax at source under section 195 of the Act.

FM COMMENTS:

The taxation of royalty has always been a vexed issue in the Indian context. There have been conflicting rulings on the issue relating to the characterization of payments towards the purchase of computer software. This is indeed a welcome ruling, which has finally put to rest a long litigation.

However, it is pertinent to note that the Finance Act, 2020 has introduced the provisions of ‘equalisation levy’ leviable on a non-resident e-commerce operator from e-commerce supply of services. These transactions are exempted from Income-tax under section 10(50) of the Act.

Further, vide, Finance Bill 2021, it has been clarified that exemption under section 10(50) will not apply to royalty or fees for technical services, that are taxable under the Act read with the DTAA. Hence, as a corollary, it may be deduced that, based on this SC ruling, if a non-resident takes shelter under the DTAA, for payments that are made to it for purchase of computer software, the non-resident could still be liable to pay equalisation levy on the satisfaction of certain prescribed conditions. It is therefore advised that going forward, such issues are analysed carefully and separately, before arriving at any conclusion on the effective taxability that arises. Additionally, in cases where the payments are being made to parties residing in non-DTAA countries, suitable arguments would require to be made, on a case-to-case basis using this decision as a persuasive tool.

1 Civil Appeal Nos 8733 – 8734 of 2018
2 [2020] 271 Taxman 200 (SC)
3 [2004] 271 ITR 401
4 [2010] 327 ITR 456
This article expounds a recent decision regarding tax liability on the purchase of computer software from a non-resident distributor/ manufacturer.

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