Software - A copyrighted article - Hullabaloo on misunderstanding Indo-USA tax treaty!

APRIL 4,2009

By Surendra Bhargava

THE question whether income from licensing of software by a foreign licensor to Indian cellular operator arose in the case of LUCENT TECHNOLOGIES INTERNATIONAL INC v DCIT (2009-TIOL-161-ITAT-DEL) was business profits under DTAA. AO takes the view that its subsidiary is the dependent agent of the assessee, treats the same as its PE and also treats the payments arising out of transfer of right to use of software as royalty payment. CIT(A) partly disagrees with the AO that the assessee has a PE in India but confirms that the payments made for transfer of software is royalty income taxable in India. Tribunal held, since the details of the agreement and other facts are similar to the Motorola Inc decided by the Special Bench and the same decision being a binding on the Bench, and also the fact that the assessee had not transferred the right to the Indian Cellular operator to duplicate or adapt or use the same in public, it was a mere transfer of a copyrighted article and not the copyright. Income is not royalty either under the domestic law or the DTAA. CIT(A) order disallowed and the Assessee's argument upheld.

In this write up, we will consider the correctness of the decision of the Tribunal in the case of L and more so in the case of Motoola Inc.

Tribunal, in the fomrer case, started (para 14 & 15):

‘The main issue which is required to be considered and decided by us in the present context is whether the payment received by the assessee under the license agreement for allowing use of the software is in the nature of royalty income or it constitutes the business profit of the assessee. The issue as to whether the same is in the nature of royalty is required to be decided in the light of Article 12 of the relevant Double Taxation Avoidance Agreement (DTAA in short).

The crux of the issue thus is whether the payment received by the assessee under the license agreement is for a copyright or copyrighted article and as held by the Special Bench of ITAT in the case of Motorola Inc. (supra), if it is for a copyright, it should be classified as royalty both under the Income-tax Act (Act) and under the DTAA. On the other hand, if the payment is actually for a copyrighted article, then it only represents the purchase price of the article and the same, therefore, cannot be considered as royalty either under the Act or under the DTAA.

Tribunal quoted from the special bench order, as under:

‘First of all, a reference was to the definition of “copyright” as given in section 14 of the Copyright Act, 1957 wherein it was defined as the exclusive right to do or authorize the doing of any of the following acts in respect of a work or any substantial part thereof viz. :—

“(a) in the case of a literary, dramatic or musical work, not being a computer programme,

(i) to reproduce the work in any material form including the storing of it in any medium by electronic means;

(ii) to issue copies of the work to the public not being copies already in circulation;

(iii) to perform the work in public, or communicate it to the public;

(iv) to make any cinematograph film or sound recording in respect of the work;

(v) to make any translation of the work;

(vi) to make any adaptation of the work;

(vii) to do, in relation to a translation or an adaptation of the work any of the acts specified in relation to the work in sub-clauses (i) to (vi);

(b) in the case of a computer programme,—

(i) to do any of the acts specified in clause (a);

(ii) to sell or give on commercial rental or offer for sale or for commercial rental any copy of the computer programme :

Provided that such commercial rental does not apply in respect of computer programmes where the programme itself is not the essential object of the rental;

(c) in the case of an artistic work,—

(i) to reproduce the work in any material form including depiction in three-dimensions of a two-dimensional work or in two-dimensions of a three-dimensional work;

(ii) to communicate the work to the public;

(iii) to issue copies of the work to the public not being copies already in circulation;

(iv) to include the work in any cinematograph film;

(v) to make any adaptation of the work;

(vi) to do in relation to an adaptation of the work any of the acts specified in relation to the work in sub-clauses

(i) to (iv);

(d) in the case of cinematograph film,—

(i) to make a copy of the film, including a photograph of any image forming part thereof;

(ii) to sell or give on hire, or offer for sale or hire, any copy of the film, regardless of whether such copy has been sold or given on hire on earlier occasions;

(iii) to communicate the film to the public;

(e) in the case of a sound recording,—

(i) to make any other sound recording embodying it;

(ii) to sell or give on hire, or offer for sale or hire, any copy of the sound recording, regardless of whether such copy has been sold or given on hire on earlier occasions;

(iii) to communicate the sound recording to the public.

Explanation - For the purposes of this section, a copy which has been sold once shall be deemed to be a copy already in circulation.” (para 16)

It was noted by the Tribunal from the aforesaid definition that the right mentioned in sub-clause (2) of clause (b) of section 14 is available only to the owner of the computer programme. According to the Tribunal, it, therefore, followed that if the licensees do not have any of such rights as mentioned in clauses (a) & (b) of section 14, it would mean that they do not have any right in the copyright and in such a case, the payment made to them could not be characterized as royalty either under the Income-tax Act or under the DTAA.

The Special Bench of the Tribunal then proceeded to examine from the relevant license agreement as to whether any of the licensees was allowed to exercise any such rights mentioned in the relevant provisions with reference to the software provided by the assessee. On such examination, it was noted by the Tribunal from the relevant clause of the agreement that the licensee was granted a non-exclusive restricted license to use the software but only for its own operation and not otherwise. The licensee thus was permitted to use the software for the purpose of its own operation and there was a clear bar on the software being used by the licensee in the public domain or for the purpose of commercial exploitations. The grant of a non-exclusive restricted license to use the software again meant that the supplier of the software could supply similar software to any number of persons to which the licensee could have no objection. As held by the Tribunal, the words “restricted” and “not otherwise” used in the relevant license agreement thus were sufficient to show that the licensee had a very limited right so far as the use of software was concerned and the licensee thus had not been given any of the seven rights mentioned in clause (a) of section 14 or the additional rights mentioned in sub-clause (2) of clause (b) of that section which related to a computer program. The Special Bench of the Tribunal thus held that what the licensee/user of the software had acquired under the license agreement was not a copyright but was a copyrighted article.

The Tribunal then took note of the stringent restrictions imposed on the licensee under the license agreement so far as use of the software was concerned and found that the licensee had been denied the right of making the copies of the software or parts thereof except for archival back-up purposes. This meant that the licensee could not make copies of the software for commercial purposes which condition was contrary to section 14(a)(i) of the Copyright Act which permits the copyright holder to reproduce the work in any material form including the storing of it in any medium by electronic means. Referring to section 52(1)(aa) of the Copyright Act, it was also held by the Tribunal that merely because the licensee had been permitted to take copies just for back up purposes, it could not be said that he had acquired a copyright in the software. The Tribunal also took note of the restrictions placed on the licensee not to license or sell the software which was running counter to section 14(b)(ii) of the Copyright Act which permits a copyright holder to sell or let out on commercial rental the computer program. It was held by the Tribunal that even from this angle, it could not be said that the licensee had acquired a copyright in the software.

The Special Bench of the Tribunal in the case of Motorola Inc. (supra) thus held on a conjoint reading of the terms of the license and the provisions of Copyright Act, 1957 that the licensees were not allowed to exploit the computer software commercially which was the essence of the copyright. What the licensee had acquired under the license agreement was only the copyrighted software which was an article by itself and not any copyright therein. The Tribunal also referred to the third edition of Aiyengar’s Copyright Act wherein it was observed that the transfer of the ownership of a physical thing in which copyright exists gives the purchaser the right to do with it in physical form whatever he pleases except the right to make copies and issue them to the public. Relying on the said observation, the contention raised on behalf of the revenue that if a person owns a copyright article, then he automatically has a right over the copyright also was found to be not acceptable by the Tribunal. It was observed by the Tribunal in this context that even though one cannot have the copyright right without a copyrighted article, it does not follow that one having the copyrighted article has also the copyright in it.

The Tribunal then referred to paragraph 14 of the Commentary on OECD Model Convention (dated 28-1-2003) which reads as under:—

“14. Commentary on Article 12.—Paper Book V - In other types of transactions, the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the programme for example, where the transferee is granted limited rights to reproduce the programme. This would be the common situation in transactions for the acquisition of a programme copy. The rights transferred in these cases are specific to the nature of computer programmes. They allow the user to copy the programme, for example onto the user’s computer hard drive or for archival purposes. In this context it is important to note that the protection afforded in relation to computer programmes under copyright law may differ from country to country. In some countries the act of copying the programme onto the hard drive or random access memory of a computer would, without a license, constitute a breach of copyright. However, the copyright laws of many countries automatically grant this right to the owner of software which incorporates a computer programme. Regardless of whether this right is granted under law or under a license agreement with the copyright holder, copying the programme onto the computer’s hard drive or random access memory or making an archival copy is an essential step in utilizing the programme. Therefore, rights in relation to these acts of copying, where they do no more than enable the effective operation of the programme by the user, should be disregarded in analyzing the character of the transaction for tax purposes. Payments in these types of transactions would be dealt with as commercial income in accordance with article 7.”

According to the Tribunal, the Commentary on OECD Model Convention although was of persuasive value only, the same threw considerable light on the character of the transactions and the treatment to be given to the payments for tax purposes.

The Tribunal also referred to the proposed amendments to regulations of the International Regulation Service (IRS) in the US and found that a difference between a copyright right and the copyrighted article was clearly made out therein. It was also mentioned therein that if the transferee acquires a copy of the computer programme but does not acquire any of the rights specified in certain sections of the US Regulations, the regulation classified the transaction as the transfer of the copyrighted article and not the transfer of a copyright right. The rights identified in the US Regulations in this context as taken note of by the Tribunal in paragraph 168 of its order were as under:—

“(i) The right to make copies of the computer programme for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending.

(ii) The right to prepare derivative computer programmes based upon the copyrighted computer programme.

(iii) The right to make a public performance of the computer programme.

(iv) The right to publicly display the computer programme.”

The Tribunal also referred to the Commentary of ‘Charl P.du TOIT’ on this issue wherein it was opined that articles such as books and records are copyrighted articles and if they are sold, the user does not obtain the right to use any significant rights in the underlying copyrights itself which is what should determine the characterization of the revenue as sale proceeds rather than royalties. The Tribunal thus held that the payment by the transferee was not for any copyright in the software but the same was only for the software as such as the copyrighted article and the payment for such transfer, therefore, could not be considered as royalty within the meaning of Explanation (2) below section 9(1)(vi) of the Income-tax Act or the relevant article of the DTAA.
5. It seems, neither the DR or AR nor the Tribunal referred closely to the definition of ‘royalty’ in the Indo-USA DTAA. It was also not consdiered in the Motorola’s case. ‘Royalty’ is defined in the DTAA, as underLtaken from incometaxindia site)

The term royalties as used in this Article means :

(a) payments of any kind received as a consideration for the use of, or the right to use, any copyright or a literary, artistic, or scientific work, including cinematograph films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property which are contingent on the productivity, use, or disposition thereof ; and

(b) payments of any kind received as consideration for the use of, or the right to use, any industrial, commercial, or scientific equipment, other than payments derived by an enterprise described in paragraph 1 of Article 8 (Shipping and Air Transport) from activities described in paragraph 2(c) or 3 of Article 8.

In this write up, we are not considering, whether the use of software may also fall, under ‘equipment royalty’, defined in sub-clause (b), above. However, we will discuss this provision, to elaborate the phrase, ‘use of, the right to use, any literary work’.

The portion of the Technical explanation of the DTAA issued by USA treasury, on this definition, is extracted in the Annexure. However, relevant part of the explanation is reproduced below:

‘Subparagraph (a) of paragraph 3 defines the term royalties as used in Article 12 to mean payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work, including cinematographic films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial, or scientific experience.’

Whereas the words used in the definition are:’ use of, or the right to use any copyright or a literary, artistic, or scientific work’, the technical explanation elaborates it as follows:‘use of, right to use, any copyright of a literary, artistic, or scientific work’

Whether substititution of the word ‘or’ in the definition by the word ‘of’ is significant can be understood by referring to similar definition in some other treaties with Armenia, Austria, Bangladesh, Belarus, Belgium, Brazil, Bulgaria, China, Czech, Denmark, France, Germany, Indonesia, UK, Canada, Sweden, Finland, etc. All of them uses the phrase:‘use of, the right to use, any copyright of a literary, artistic, or scientific work’, Similar phrase is used in OECD, US & UN model.

Australian, Cyprus DTAA, Malta, in contrast, has the following comparable definition: ‘the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark or other like property or right’.

Thus, under the US DTAA, consideration will be ‘royalty’, if the use or right to use, is of ‘literary work’ or any ‘copyright’. Whereas, under OECD, US and other Indian DTAAs, the royalty will only be when there is use, or the right to use, any copyright of literay work, in Australian DTAA, the same restriction is achieved by use of phrase ‘other like right’. In contrast, US DTAA taxes, consideration for the use of, the right to use, not only any copyright, but literary work simiplicter. Thus, neither, we need to refer to ‘copyright’ or ‘right in the copyright’. Discussion by the Tribunal in the Motorola’s case, to the Copyright Act, OECD commentry, US regulations and commentary of ‘Charl P.du TOIT’, could not be relevant. Consideration paid in the Motorola or L for the use of, or the right to use, computer software/literary work, would be taxable as ‘royalty’ under the Indo-US DTAA. Had the Tribunal, in both these cases, considered the impact of the word ‘or’ in Indo-US DTAA, in the view of the author, its decision would have been different.

In para 141.1 of the Report in Motorola’s case, the assessee argued that section 2(o) of the Copyright Act defines ‘literary work’ to include computer programmes, tables and compilations including computer databases. Classified as such, it is not permissible to treat it forming part of clause (i) to (iv) of Exp 2 to section 9(1)(vi).

Tribunal, in the Motorola’s case, did not reproduce the definition of ‘royalty’, under the Act, although there is discussion in this regard in para 141.3 of the report. We, first, reproduce the relevant portion of the definition, given in 9(1)(vi) Exp 2(v), below:
‘The transfer of all or any rights (including the granting of a license) in respect any copyright, literary, artistic or scientific work…

In the case of Motorola, the licensee was granted a non-exclusive restricted license to use the software but only for its own operation and not otherwise. The Tribunal also referred to the third edition of Aiyengar’s Copyright Act wherein it was observed that the transfer of the ownership of a physical thing in which copyright exists gives the purchaser the right to do with it in physical form whatever he pleases except the right to make copies and issue them to the public.

Both in Motorola and in L, the Indian cellular operator, Tribunal held that the payment by the transferee, was not for any copyright in the software but the same was only for the software as such as the copyrighted article. Thus, consideration was for ‘the transfer of any rights (including the granting of license) in respect of literary work’. It was covered by the definition of ‘royalty’ under the Act. Tribunal did not consider the definition of ‘royalty’ under the Act. Has it done so, its decision would have been in favour of the Revenue.

The above survey shows that the definition of ‘royalty’ under the Indo-US DTAA is different than in various Indian DTAAs or similar definition under US & OECD models. The interpretation put on this definition by the Tribunal in the case of L or Motorola does not seem to be correct. Sooner it is reviewed, better it is for removing the uncertainty.

Bhargava is former Chief Commissioner of Incometax and runs NGO ‘Institute for Improved India’. Article is based on discussion in his forthcoming book on ‘Royalty & Technical services’.