E-commerce has already fundamentally changed how we transact business. Moreover, the rapid growth of this technology in just a few short years is a clear harbinger of much more pervasive changes just around the corner. While these innovations have created new opportunities for some businesses, they have been truly frightening to governments across the globe. The very nature of Internet, its complexity, mobility, adaptability, and potential for growth raise real questions as to its taxability. The various legislations contain few specifics in this regard. The issue is not, however, totally without guidance. Technical interpretations by the OECD and renowned authors and judicial rulings do provide some indication of its position on the various questions related to the taxation of software payments.

The broad principles that govern taxability of e-commerce as set out in the OECD Model Commentary (“OECD MC”) are neutrality between forms of e-commerce and other conventional forms of commerce. The basic principle is that business decisions ought to be motivated by economic rather than tax considerations. The systems for taxation should be flexible and dynamic to ensure that they keep pace with technological and commercial developments.

There are typically two broad modus operandi much in vogue for receipt of software services– service through a website/internet or outright sale of software & rights attached therewith. The issues that arise in context of taxability of these services relate to creation of a permanent establishment (“PE”) and characterization of income so received as royalty or business income.

The OECD spells out a distinction between a web site, a server and operators thereof for the creation of a PE. There are discussions and guidance on the issue but no finality in the matter has been achieved. A variety of issues have sprung up in this respect viz. location of server or place of receipt of service, nature of activities performed by the computer equipment, whether service provider to constitute a PE.

Sale of software throws up issues in relation to treatment of income arising therefrom ie nature of rights acquired by the transferee, supply of information regarding software, transfer of hardware & software under a composite contract, the nature of delivery mechanism etc.

OECD Committee on Fiscal Affairs set up The Technical Advisory Group (TAG) on Treaty Characterization Issues arising from E-Commerce to examine characterization of various types of e-commerce payments under tax conventions to provide the necessary clarifications in the OECD MC. The committee brought out a comprehensive report which discusses at length the various issues involved in a transaction of sale of software. The report illustrates various categories of typical e-commerce transactions and analysis of the taxability of such payments.

E-services may be classified as either business income or royalties. Electronic order processing of tangible goods and delivery of the same whether by actual physical delivery or direct downloading from the server is clearly business income. Any updates or add ons to these goods will also be similarly classified. Payments from sale of limited duration software and other digital information licenses liable to be discarded after termination of the license period, will also be construed likewise. Even in case where the customer receives a right to copy the software in usable form on floppy/CD, since the same become unusable on expiry of the license, it would not alter its stand as regards taxability.

Some special kind of software will be usable only when loaded on the server of the facility provider. In such case, payments will be in lieu of usage of the server facility and hence constitute business income.

Another like category of payments for software could be a situation where the owner of a server provides space to host a web site on its server and receives consideration for the same.

But, when this purchase of software involves commercial exploitation of the copyright embedded therein, the payment will qualify as royalty.

The test for characterization of income from such payments as laid down by the OECD may be summed as: if payments are for rights to use copyright, then royalty; if the use of copyright is only incidental, then business income and if for a copyrighted article, then business income.

The broad principles spelt out by OECD have been imbibed in taxing software payments across the world.

The European Union is of the view that the existing framework of taxation should be extended to e-commerce as well and no new taxation rules be brought out. For VAT purposes, sales of good online is treated in the same way as any other form of distance sales (e.g., from catalogues, by phone, post, etc.). Electronic transmissions, on the other hand, are taxed as services.

The United States (“US”) adopted the Internet Tax Freedom Act (“ITFA”) which prohibits the states of the US from imposing any tax on Internet access or any multiple or discriminatory taxes on e-commerce on the basic principle of neutrality between forms of commerce. Judicial rulings in the US hold canned or pre-written software liable to sales tax. Litigation began as early as 1969 in the US on bundled and un-bundled software and composite contracts for software and hardware. Controversy arose as to whether software was a tangible or intangible good, tangible goods being taxable in the prevalent tax regime. The US also brought out special notices from time to time in the nature of clarifications on taxability of canned software and professional services.

The contention of the Canadian IRS is that payments for shrink-wrap software are not royalty payments but instead represent payments for the sale of a tangible good and accordingly, not subject to withholding tax. Payments for custom software however, are treated as royalty payments, subject to withholding tax in the absence of treaty relief. Custom software is defined as computer software that requires the end-user to enter into a specific licensing agreement with the licensor concerning the use of the software.

Australian Rulings proclaim computer software produced or developed for sale by a software manufacturer or developer, or acquired for sale by a distributor, in the course of business as trading stock.

The surge of e-commerce took time to usurp India, but has today become an integral part of the Indian economy. No specific legislations have been brought out which spell the law in this regard and litigation finds it basis from inferences and analogies drawn from the facts of each case.

One of the earliest decisions in India spelt out in February 2001 was Skycell Communications in respect of telephony services, the new technology of that time. The Chennai High Court held that subscription fee paid for using a cellular telephone service does not tantamount to receipt of a technical service despite employing sophisticated technical equipments for providing such service. Similarly, Wipro had paid sums to non-resident telecom companies for down-linking and transmission of data and software to its customers outside India and it was held that it cannot be considered as ‘fees for technical services’ or ‘royalty’ since no process was made available to it.

The Bangalore ITAT in Lucent Technologies held that where purchase of software was inextricably linked to the purchase of hardware and the software could not have been used in isolation, bifurcation of a single transaction into purchase of hardware and software and treating the purchase of software as payment for royalty was not possible. The proposition may however be refuted in light of a recent decision of the Supreme Court in State of UP v. UoI where it was held that supply of telephone instruments was considered as sale of goods whereas, supply of telegraphic line/connection was considered as provision of service. The Chennai ITAT in the decision of Raj TV held that payment of charges for hire of transponder and up-linking services was not covered within the definition of ‘royalty’ as envisaged under the Act. On whether the payment could constitute FTS, it was observed that no service, whatsoever, was intended to be rendered, either technically or otherwise. Divergent views arose on account of the Delhi Tribunal decision in case of Asia Satellite Telecommunications Co. Ltd. wherein lease rent received for hiring transponders was considered as royalty. The Supreme Court of India had the opportunity of examining software payments for the levy of sales tax. In the much celebrated decision of Tata Consultancy Services, it was held that computer programmes installed in a medium would become tangible, movable and available in the market and hence, would be termed as goods and not as intellectual property. The Authority for Advance Rulings examined the characterization of software payments in the American Express ruling and held payments for use of CPU as royalty on the premise that the same is not merely for use of equipment but for the use of a sophisticated facility. In another decision relating to Wipro, payment of annual subscription for access to copyright material from the data server located outside India was not to be termed as payment for royalty. A recent decision of the same forum is in the case of Samsung Electronics which delves into the various issues and refers many relevant decisions of Indian and foreign courts to hold that payments made for the purchase of “off the shelf“software will not be considered as payment for the use of or right to use copyright and hence, not categorized as royalty. Analogy was drawn from the various copyright acts of different countries to bring out the distinction between a “copyright” and a “copyrighted article” for categorization as royalty or business income.

The authors are members of the Institute. The views expressed herein are their personal views and do not necessarily represent the views of the Regional Council. They can be reached at manvi.sharma@bmrtax.com and gchandrashekhar@bmrtax.com respectively.