India tax: High Court rules on withholding tax on purchase of shrink-ware
On 24 September 2009, the Indian High Court of Karnataka reversed the order of the Bangalore Income Tax Appellate Tribunal (ITAT) on the applicability of withholding tax on the purchase of "shrink-wrap" or "off-the-shelf" software. This issue has been very controversial, with the ITAT concluding that payments made for the purchase of such software are not a royalty and, consequently, there was no liability for the payer to withhold tax. While the appeal addressed separate ITAT decisions affecting different taxpayers/years, the High Court considered the facts of Samsung Electronics Co. Ltd (assessee) in holding that any payment to a nonresident would attract withholding tax in the absence of an order from the tax authorities providing for a zero or reduced rate of withholding (Samsung Electronics Co. Ltd and others, ITA No.2808 of 2005). The High Court did not, however, make a determination on whether the payments were in the nature of a royalty.
Samsung involved an assessee engaged in developing, manufacturing and exporting software for use by its parent company. The assessee purchased off-the-shelf software from countries such as France, Sweden and the U.S. for use in its business, but did not withhold tax on the amounts payable for the software (nor did it request permission from the tax authorities not to withhold tax), believing that the payment did not fall within the meaning of "royalty" under the Indian Income Tax Act, 1961 (ITA) or the relevant tax treaties. The Indian tax authorities, however, took the position that the payment was in the nature of a royalty under both the ITA and the treaties.
On appeal, the ITAT held in favor of the assessee, concluding that the payment for the purchase of shrink wrap software was in the nature of a payment for the "purchase of goods," not a royalty, and that, if the payment was not taxable in India, the withholding tax provisions did not apply. The Indian tax authorities appealed the ruling of the ITAT, arguing that the assessee's payment was in the nature of a license fee and not compensation for an outright sale because the copyright in the software remained with the transferor. The assessee was therefore required to deduct tax on the payment.
The assessee argued that the withholding tax provisions are applicable only where the income concerned is chargeable to tax in India. Several factors militate against finding that the payment for the purchase of the software was in the nature of a royalty, including that the definition of royalty in the relevant treaties does not mention "software" and the payment was made to acquire a copy of a copyrighted article and not the acquisition of the copyright itself. Finally, even if the payment is considered a royalty under the ITA, it does not retain the character of a royalty under the treaties, the provisions of which (being more beneficial) would apply. The assessee also argued that the income from the sale of software was a trading receipt and taxable in India only if it arose in India. Because the payment was made outside India, it was not chargeable to tax in India and the assessee was not liable to deduct tax thereon. Such payments, the assessee argued, are business income in the hands of the recipient and are taxable in India only if the recipient has a permanent establishment in India.
Finally, the assessee argued, with respect to the tax authorities' reliance on the Transmission Corporation case, that the case did not consider the consequences where a sum payable to a nonresident is not chargeable to tax at all. Further, that case cannot be considered as authority for holding that, even where there is no chargeability, there is an obligation to deduct tax at source, unless the payer has gone through the process of obtaining a withholding certificate from the tax authorities that provides for a lower or nil rate.Ruling of the High Court
In issuing its decision, the High Court laid down several points of law. To begin with, the Indian Supreme Court's ruling in Transmission Corporation, in which the court held that any payment to a nonresident triggers a withholding obligation unless a nil withholding order has been obtained from the tax authorities, is binding on all Indian courts. Additionally, ITA section 195, which provides for withholding tax on payments to nonresidents, is neither a charging section nor a section providing for the determination of the tax liability of a nonresident in receipt of payments from a resident. It is only necessary for a payment that has the semblance of income to be made to a nonresident to trigger the obligation of the payer to withhold tax under section 195 at the time of payment. The payer cannot avoid this obligation by contending that the payment does not result in income under the ITA or a relevant treaty. The only (limited) way for a resident payer to avoid or reduce the withholding tax obligation is to apply to the tax authorities under section 195(2) for a lower or nil withholding tax rate.
Moreover, in examining an application for a lower/nil rate, the assessing officer cannot embark on an exercise to determine the actual tax liability of the nonresident. If a payer does not apply to withhold at a lower or nil rate and an appeal is filed against an Assessing Officer's order holding the payer in default for failure to withhold tax, the appellate authority is precluded from determining the liability of the nonresident in respect of the payment received for purposes of determining whether and to what extent the payer may be relieved from the obligation to deduct tax at source. Further, such an appeal cannot be used to correct the order on the grounds that the receipt of income by the nonresident was outside the scope of taxation under the ITA. The Tribunal was clearly in error in allowing the taxpayer to seek a determination of the nonresident recipient's tax liability. Consequently, the High Court held that none of the orders of the Tribunal in this case are sustainable.Conclusion
The High Court's decision (which is binding on the appellate authorities in the State of Karnataka, but may have persuasive value throughout India until the High Court of another state issues a contrary decision) is significant because it requires tax to be withheld on every kind of payment to a nonresident unless the payer submits an application to the Indian tax authorities for a reduced or zero rate. Also important is the fact that the High Court did not rule on the merits whether the payments for off-the-shelf software constituted a royalty under the ITA or the treaties. Further litigation against the High Court's order may be expected. In the meantime, the tax authorities may aggressively enforce the withholding tax provisions with respect to both past and future payments to nonresidents.