I. Introduction
Under the Income-tax Act, 1961 ('Act'), to determine the tax liability, it is essential to assess the residential status of the assessee. When the assessee is a non-resident or a foreign entity doing business in India, determining their tax liability becomes complex. This complexity arises because such an assessee earns income in both India and their country of residence, necessitating the application of both source and residence rules.
The Act contains certain deeming provisions that lay down the circumstances under which income shall be 'deemed to accrue or arise' in India and hence be taxable in India. However, problems often arise when a non-resident or a foreign entity is taxed in India and its respective country of residence because of such deeming provisions. This is known as double taxation. To avoid double taxation, the governments of different countries enter into agreements with other countries to determine the tax liability of non-residents and foreign companies. The government of India has also entered into such agreements with various countries to avoid double taxation of such entities. Such agreements are termed double taxation avoidance agreements ('DTAA').
Tax treaties or DTAAs play a key role in international taxation by providing a basis to avoid double taxation and prevent tax evasion. These treaties are entered into between the contracting states after negotiations between the two or more states and finally agreed upon to determine the taxing rights over income earned by residents of the contracting states. One of the main aspects of these treaties is that they allow taxpayers to choose between the provisions of the Act and the treaty provisions, whichever is more favourable. This choice, embedded in s. 90(2) of the Act offers taxpayers the opportunity to minimise their tax liability through strategic planning.
II. Incomes deemed to accrue or arise in India
S. 9 of the Act deals with the 'incomes which are deemed to accrue or arise in India'. Royalty and fees for technical services ('FTS') are two specific streams of income that are liable to tax in India under the deeming fiction, regardless of whether the income-generating activity has been performed in India or not. It is pertinent to understand that royalty/FTS income is taxed as per the source rule1. The 'Source State Taxation' rule grants primary taxing rights to the country where the income originates. The source rule applies where business activity is wholly or partly performed in a source state2.
What is Royalty?
In the Act: Explanation 2 to s. 9(1)(vi) of the Act broadly defines royalty to include payments made to the non-resident/foreign entity for the use of or right to use any patent, invention, model, design, secret formula, process, trademark, or similar property. It also encompasses consideration for the transfer of all or any rights in respect of such property, including granting a license and imparting any information concerning the working of, or the use of, a patent or other similar property.
However, if the non-resident (NR)/foreign entity makes the outright sale to an Indian concern, then capital gains shall arise in the hands of the NR/foreign entity, and thus, this would not be royalty.
The definition of royalty went through various amendments from time to time, and now it also includes the consideration received by an NR/foreign company for:
- Providing/imparting any information on how to use or operate a patent, invention, model, design, secret formula, process, trademark or similar property.
- Using any invention, model, design, secret formula, process, trademark or similar property.(Note: In this case, there is neither any transfer of any property as mentioned above nor the imparting of any information. It is the mere use of the rights in the above-mentioned property which will be charged and be termed as royalty.)
- Provide/impart any information about technical, industrial, commercial or scientific knowledge, experience or skill. (Note: Not every instance of providing technical, commercial, industrial, or scientific knowledge or skill is considered royalty. For example, in a contract for supplying equipment, giving information to help the buyer install and use the equipment would not be considered royalty.)
- The use or right to use any industrial, commercial or scientific equipment, excluding amounts mentioned in s. 44BB of the Act. (For example, a machine rented by an Indian company for its use would fall under this clause.)
- The transfer of all or any rights (including granting a license) related to any copyright, literary, artistic, or scientific work, including films or videotapes for use in connection with radio broadcasting, telecasting, etc.
- Providing any services related to the activities mentioned in the above clauses.
In Treaties: The definition of royalty in tax treaties generally aligns with the UN Model Convention ('MC') or the OECD MC, although variations exist.
According to the UN MC, royalty refers to payments made for the use or the right to use various forms of intellectual property. This includes the use of copyrights on literary, artistic or scientific works, such as films or tapes used in radio or television broadcasting. It also covers the use of patents, trademarks, designs or models, plans, secret formulas or processes, and industrial, commercial or scientific equipment. Moreover, royalty payments can be made for access to information related to industrial, commercial, or scientific experience.
According to the OECD Model Convention (OECD MC), royalty is similarly defined as payments received for the use or the right to use any copyright on literary, artistic, or scientific work, including cinematograph films, patents, trademarks, designs or models, plans, secret formulas or processes, or access to industrial, commercial, or scientific experience.
It is important to note that most DTAAs India has signed are based on the UN MC. However, each specific DTAA contains its own definition of the term 'royalty.' To determine the applicability and scope of 'royalty' taxation in a particular situation, it is essential to carefully review how the term 'royalty' is defined in the relevant DTAA. This definition guides the interpretation and application of tax rules related to royalty payments under that specific agreement.
Definition of Fees for Technical Services (FTS)
In the Act: Explanation 2 to s. 9(1)(vii) of the Act defines FTS as any payment made in exchange for providing managerial, technical, or consultancy services, including the provision of technical or other personnel. However, this definition specifically excludes payments made for any construction, assembly, mining, or similar projects undertaken by the recipient. It also excludes any payment that would be considered income under the category of 'salaries'.
In Treaties: Tax treaties often define FTS similarly but can vary based on whether they follow the OECD or UN MC. The UN MC includes a more detailed definition, capturing payments for services of a managerial, technical, or consultancy nature provided by a resident of one contracting state to a resident of another, whereas the OECD MC does not specifically define FTS, leading to reliance on domestic laws for interpretation.
III. Common Disputes
As seen above, the definitions of royalty and FTS differ in different models and DTAAs. Therefore, various controversies arise due to the interpretation of these terms, and consequently, disputes arise as to the applicability of tax provisions to the income generated from such transactions. Below are some common disputes concerning the taxability of these incomes.
A. Interplay between DTAA and the Act
The interplay between the Act and DTAAs is a critical aspect of determining international taxation in India. DTAAs are bilateral agreements between two countries (contracting states) to avoid double taxation on the same income. Generally speaking, these agreements provide relief to taxpayers who would otherwise be subject to tax in both countries. However, conflict arises when there is an inconsistency between the provisions of the Act and those of the DTAAs, which gives rise to complex issues and leads to disputes, often settled by judicial interpretation.
The primary issue is the determination of taxability under the DTAA versus the Act, particularly concerning royalty and FTS. Time and again, a question is raised as to whether the taxpayer can choose the taxability of their income under the Act or the DTAA when one is more beneficial than the other. The Courts have held it that s. 90(2) of the Act allows taxpayers to choose the most beneficial provision, whether from the DTAA or the Act. Moreover, a taxpayer can simultaneously apply provisions from the agreement and the Act to maximise benefits. Further, it is a settled position that if an income is not taxable under the Act, the DTAA cannot create a tax liability. Conversely, if the income is taxable under the Act but exempt under the DTAA, the provisions of the DTAA will prevail. Taxpayers can select the more beneficial option annually. However, if a taxpayer opts out of being assessed under the DTAA, they cannot seek treaty protection for specific assessment aspects later.
In the landmark case of Azadi Bachao Andolan v. UOI3, the Supreme Court, while upholding the validity of the India-Mauritius DTAA, allowed the foreign investors to avail the benefit from the treaty's favourable provisions as they were more beneficial than the domestic law. The Supreme Court observed that the effect of an agreement entered into by virtue of s. 90 of the Act would be that if a tax liability is imposed by this Act, the agreement may be resorted to for negativing or reducing it and in cases where there is a difference between the provisions of the Act and the agreement, the provisions of the agreement would prevail over the provisions of the Act and can be enforced by the Court. The Supreme Court reasoned that since the DTAAs are designed to promote international trade and investment, their provisions should be interpreted in a manner that furthers these objectives.
B. Common Disputes in Royalty
The concept of 'royalty' under the Act has been a hotbed of disputes in India, especially in the context of cross-border transactions. As globalisation has fostered an increasingly interconnected economy, the definition and taxability of royalty payments have evolved, leading to various legal interpretations and controversies. The complexity is further compounded when international transactions and DTAA provisions are involved. Taxpayers and authorities often find themselves at odds over the interpretation and application of these provisions, leading to numerous legal disputes.
(i) Characterization of Royalties
One of the most common disputes concerns the characterisation of payments made by an Indian entity to a non-resident. The key question involved is whether the payment made by the Indian entity qualifies as royalty or should it be considered as business income. This question is crucial considering the difference between what qualifies as royalty and business income. The reason for this is that under the DTAAs, business income is generally taxable in India only if the non-resident has a permanent establishment ('PE') in India, whereas royalty income is taxable irrespective of the presence of a PE in India.
The Supreme Court, in the case of Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT4, resolved one such dispute. The Court held that payments made by Indian end-users/distributors to non-resident computer software manufacturers/suppliers for the resale/use of software are not in the nature of royalty. Instead, these payments should be classified as business income, not taxable in India in the absence of a PE.
(ii) Issue around Taxability of Software Payments
Payments made for software licensing have been a contentious issue, with the revenue often treating such payments as royalties. The revenue's primary argument has been that software licences involve the use of copyright, falling within the ambit of royalty. On the other hand, the taxpayers contend that these transactions involve the sale of copyrighted articles rather than the transfer of copyright and, hence, should not be taxed as royalty.
Controversy revolving around the taxability of software payments was sought to be resolved by amendment to s. 9(1)(vi) of the Act by Finance Act of 2012. The Finance Act has inserted Explanation 4 to the s. 9(1)(vi) with retrospective effect. This explanation has expanded the definition of royalty to include software payments. However, often reliance is placed upon the decision of the Hon'ble Supreme Court in Tata Consultancy Services v/s State of Andhra Pradesh5, which held that software embedded on a CD is a 'good' and is liable to sales tax, to argue that the sale of a CD with software, music, etc. embedded on it cannot give rise to 'royalty' income as the same is in the nature of the sale of goods.
In the CIT v. Samsung Electronics Co. Ltd.6, the Karnataka High Court initially upheld that what was sold by way of computer software included a right or interest in copyright, thus giving rise to the payment of royalty and would be an income deemed to accrue in India under s. 9(1)(vi) of the Act, requiring tax deduction at source. However, the Supreme Court, in the Engineering Analysis (supra), overturned this judgment, bringing significant relief to taxpayers by ruling that payments for the use of software do not constitute royalty.
(iii) Interpretation of 'Process' in Royalty Definition
Another area of dispute is interpreting the term 'process' within the definition of royalty. The revenue has often sought to expand the scope of this term to include payments for a wide range of services and technologies. However, taxpayers argue for a narrower interpretation, limiting the term to technical processes only.
In the case of DIT v. New Skies Satellites BV7, the Delhi High Court ruled that receipts of the assessee earned from data transmission services do not fall within the term royalty under the Act as they did not involve using any secret process. This decision highlighted the need to clearly understand what constitutes a 'process' under Indian law.
C. Common Disputes in FTS
The taxability of FTS under the Act has been a significant area of contention, especially in the context of international transactions. As businesses increasingly rely on specialised technical expertise, the payments made for such services often become the subject of scrutiny by tax authorities. The disputes generally revolve around the definition, scope, and interpretation of FTS under Indian tax law and relevant DTAAs. Determining whether a payment qualifies as FTS involves assessing whether the services rendered fall under managerial, technical, or consultancy categories, which is often subjective.
(i) Managerial, Technical, Consultancy Services: One of the primary disputes is the characterisation of services as technical, managerial, or consultancy. The classification is crucial because it determines whether the payment falls under the purview of FTS and is, therefore, taxable in India. Taxpayers often argue that the services rendered do not qualify as FTS under the Act or the relevant DTAA, while the tax authorities contend otherwise. These services can range widely, from managerial advice and oversight to technical services requiring specialised knowledge or consultancy services providing expert opinions. The scope of these services can lead to disputes, particularly in delineating them from ordinary business services.
In the case of CIT v. De Beers India Minerals P. Ltd8, the Karnataka High Court provided significant clarity by holding that mere technical knowledge or information is insufficient for a payment to qualify as FTS. The Court emphasised that the services must 'make available' technical knowledge, experience, skill, know-how, or processes to the recipient, enabling them to apply the technology independently.
(ii) Human Intervention: The necessity of human intervention in FTS is a crucial criterion, as seen in key judicial decisions. In CIT v. Kotak Securities Ltd.9, the Supreme Court of India ruled that services rendered through automated systems without human intervention do not qualify as technical services. Similarly, in the CIT v. Bharti Cellular Ltd.10, the Court emphasised the need for human involvement for services to be considered technical.
(iii) No Separate Definition: Often, disputes arise when FTS is either not defined in an agreement between the contracting states or is categorised in another form. For instance, In some DTAAs (such as the one with Australia), there is no separate definition for the term FTS. However, the same is included within the definition of the term 'royalty'. Further, in some DTAAs (such as Bangladesh), the FTS component is not covered within the definition of 'royalty'.
(iv) Make Available Clause: Some treaties include a 'make available' clause, stipulating that services are considered technical only if they result in the recipient acquiring technical knowledge, experience, skill, know-how, or processes. A mere rendition of services does not fall within the gamut of the term 'make available' unless the recipient of services is enabled and empowered to make use of the technical knowledge by itself in its business or for its own benefit without recourse to the original service provider in the future.11 This clause can lead to disputes over whether the service provider has indeed made such expertise available to the recipient.
(v) Taxability of Payments for Software-Related Services: Payments for software-related services have been another contentious area. The question often raised is whether these payments should be treated as FTS, royalty or business income. The classification impacts the taxability and withholding obligations of the taxpayer. For example, Payments for software maintenance services rendered by non-residents would not constitute FTS under the Act as they do not 'make available' any technical knowledge to the Indian entity.12
(vi) Overlap with Royalty and Business Income: As discussed above in some DTAAs, FTS is not explicitly defined; however, it is covered under royalty. There have been several disputes where the tax authorities have sought to classify payments as FTS even when they overlap with royalty or business income. This overlap creates confusion, especially in cases involving composite contracts where a single payment may cover various services, including technical, managerial and consultancy services. In the case of CIT v. De Beers India Minerals Pvt. Ltd.(supra), the Karnataka High Court ruled that payments for geological surveys and data analysis provided by non-residents did not constitute FTS under the Act, as they were part of a larger contract that also involved the provision of equipment and machinery. The Court emphasised the importance of analysing the substance of the contract rather than merely its form.
D. Beneficial Ownership Disputes
Beneficial ownership refers to the person or entity that ultimately owns or controls the income, even if the income is formally paid to another party. In the context of DTAAs, the concept of beneficial ownership is crucial because many treaties grant tax benefits, such as reduced withholding tax rates, only to the beneficial owner of the income.
For instance, a. 12 of the OECD Model Tax Convention, which deals with royalties, provides that the reduced tax rates or exemptions apply only if the recipient of the payment is the beneficial owner. This principle also applies to FTS, where DTAAs often contain similar provisions.
The concept of 'beneficial ownership' has become a moot point in the taxability of FTS and royalty payments under the Act, particularly in the context of cross-border transactions. Beneficial ownership is critical in determining whether an entity can claim the benefits of reduced tax rates or exemptions under DTAAs. However, the interpretation of beneficial ownership has led to significant disputes, especially when payments are routed through intermediary entities.
One of the central disputes is determining who qualifies as the beneficial owner of the income. Revenue often argues that the formal recipient of the payment is merely an intermediary or conduit and not the actual beneficial owner. This argument is typically made in cases where payments are routed through entities in low-tax jurisdictions to benefit from favourable tax treaties.
In the landmark case of Vodafone International Holdings BV v. Union of India13, the Supreme Court emphasised the importance of looking at the substance of the transaction rather than its form. Although this case primarily dealt with indirect transfers, the principles laid down by the Court are equally applicable to disputes over beneficial ownership. The Court highlighted that tax authorities must look beyond the immediate recipient of the income and examine who exercises ultimate control over the income.
The use of conduit companies to route FTS and royalty payments through jurisdictions with favourable tax treaties has led to numerous disputes. Tax authorities often deny the benefits of reduced tax rates under DTAAs, arguing that the recipient is not the beneficial owner but merely a conduit. This practice, known as 'treaty shopping,' has been a significant area of contention.
Although the revenue has been repeatedly criticised for the practice of 'treaty shopping,' the Courts in India have permitted it by regarding it as a tax incentive to attract scarce foreign capital or technology. While it is true that an international treaty between two states is not intended to confer benefits on the residents of a third state, the benefits extended to residents of the third state should not be denied unless a suitable term of limitation to that effect is incorporated therein.14
In ADIT v. Universal International Music BV15, the issue involved was that the recipient of the royalty payments, a Netherlands-based entity, was not the beneficial owner and was merely acting as a conduit for routing the payments to another entity. However, the Tribunal ruled that the benefits of the India-Netherlands DTAA could be extended to the recipient as it submitted a tax residency certificate ('TRC'), which was held to be valid proof of beneficial ownership. The Bombay High Court also upheld the said decision.
E. Triangular Problem
A triangular problem occurs when the payer, recipient, and beneficial owner of income are in different countries. The triangular problem typically arises in situations where:
- A resident of Country X provides services or licences his intellectual property to a resident of Country Y.
- An entity in Country Z, a subsidiary or a related party, pays for these services or royalties.
- The question arises as to which country has the right to tax the income: whether it should be taxed in Country X, Country Y or Country Z, and under which DTAA provisions.
This problem often leads to disputes regarding the characterisation of income, the application of withholding taxes and the interpretation of DTAAs. The complexity is compounded when different jurisdictions apply different interpretations to the same transaction, leading to double taxation or non-taxation risk.
Another contentious issue is the obligation to withhold tax on payments made in a triangular arrangement. The problem arises when the entity making the payment is unsure about the appropriate rate of withholding tax or the country to which the tax should be remitted. This uncertainty leads to various disputes between the taxpayers and the tax authorities.
F. Effectively Connected With PE
When royalties or FTS are paid to a non-resident with a PE in the source country, disputes can arise regarding whether the income is effectively connected with the PE. If so, the income is taxed as business profits under the PE provisions rather than passive income, impacting the applicable tax rate and treaty benefits. In other words, if a taxpayer has a business presence in India in the form of a fixed place PE, a service PE, dependent agent PE, etc., as per a. 5 of the DTAA, then in such a case, the taxability of the taxpayer would be governed by a. 7 relating to Business Profits provided the right or property towards which the royalty is paid is effectively connected with such PE.
G. Most-Favoured-Nation (MFN) Clause
The MFN clause is a critical component of international trade and tax treaties, designed to ensure non-discriminatory treatment between treaty partners. In the context of tax treaties, the MFN clause aims to provide equal treatment to contracting states by ensuring that a country extends any favourable tax treatment granted to a third country by its treaty partner. While the MFN clause is intended to promote fairness and consistency, its application has led to significant disputes, particularly concerning the interpretation of tax treaties under the Act.
Many tax treaties contain an MFN clause, which provides that if a contracting state enters into a subsequent treaty with a third state offering more favourable terms, those terms will also apply to the existing treaty. The MFN clause aims to ensure parity and prevent discrimination, but its application can lead to interpretational disputes and litigation. Therefore, while examining the taxability of royalty or FTS under the provisions of the DTAA, apart from the relevant article of the DTAA, it would also be critical to examine whether the DTAA has an MFN clause or not. If yes, the relevant provisions must be duly factored into the analysis.
A significant area of dispute revolves around the interpretation of the MFN clause, particularly whether it applies automatically or requires specific notification or amendment. Taxpayers often argue that it should be applied automatically, while tax authorities may insist on additional procedures or notifications.
In the case of Steria (India) Ltd. v. CIT16, the Delhi High Court interpreted the MFN clause in the India-France DTAA. The taxpayer argued that the lower withholding tax rate granted under the Indo-UK DTAA should automatically apply to France under the MFN clause. The Court ruled in favour of the taxpayer, holding that the MFN clause did not require a separate notification or amendment and that the benefits of the Indo-UK DTAA should be extended to the India-France DTAA.
The interaction between MFN clauses in tax treaties and domestic law is another area of dispute. While tax treaties often take precedence over domestic law, conflicts may arise when domestic law changes in a way that impacts the application of the MFN clause. In CIT v. Siemens Aktiongesellschaft17, the Bombay High Court addressed a situation where changes in Indian domestic law impacted the MFN clause in the India-Germany DTAA. The Court held that the MFN clause in the tax treaty should prevail over conflicting domestic law provisions, thereby ensuring that the favourable treatment under the treaty was upheld.
IV. Conclusion
The ongoing disputes surrounding the taxation of royalty and FTS in India highlight the complexity and dynamic nature of international tax law. The interplay between the Act and DTAAs forms the crux of the legal disputes, with courts frequently called upon to interpret and harmonise conflicting provisions. Key judicial decisions, such as Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT (Supra) and DIT v. New Skies Satellites BV(Supra), have provided significant clarity on issues like the classification of payments, the definition of 'process' in royalty, and the application of withholding taxes. Further, the decisions, such as CIT v. De Beers India Minerals P. Ltd (Supra) and Vodafone International Holdings BV v. Union of India (Supra), emphasised the importance of looking at the substance of the transaction rather than its form.
However, despite these landmark decisions, the fluid nature of tax law, compounded by legislative amendments and evolving global practices, continues to generate fresh disputes. As cross-border transactions increase and businesses continue to globalise, the importance of a coherent and predictable tax framework cannot be overstated. Although the judiciary has time and again stepped in to balance the rights of taxpayers with the objectives of tax authorities, the path forward remains fraught with uncertainty, particularly with emerging issues like the MFN clause and the triangular problem in multijurisdictional taxation. As the global tax environment becomes more interconnected, the need for clear and consistent legal interpretations will only intensify, making it imperative for stakeholders to stay vigilant and proactive in addressing the evolving challenges in this field. Taxes, like shadows, fall where light is cast, yet disputation makes the burden heavy, and the law's hand trembles in its grasp.
Footnotes
1 http://kb.icai.org/pdfs/PDFFile5b28becfab1417.61553097.pdf
2 GVK Industries Ltd (2015) 11 SCC 734.
3 (2004) 10 SCC 1.
4 (2022) 3 SCC 321.
5 [2004] (271 ITR 401) (SC).
6 (2012) 345 ITR 494.
7 (2016) 382 ITR 114.
8 2012 SCC OnLine Kar 8858.
9 CIT v. Kotak Securities Ltd [2016] 383 ITR 1.
10 CIT v. Bharti Cellular Ltd. [2009] 319 ITR 139.
11 Guy Carpenter &Co Ltd v ADIT (2012)( 346 ITR 504)(Delhi HC).
12 Netcracker Technology Solutions LLC v. DCIT [2020] 116 taxmann.com 243 (Mumbai-Trib).
13 (2012) 6 SCC 613.
14 Azadi Bachao Andolan v. UOI; (2004) 10 SCC 1.
15 2011 SCC OnLine ITAT 1060.
16 (2016) 386 ITR 390.
17 (2009) 310 ITR 320.
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