On August 26, 2011, an Israeli resident software company, TTI Team Telecom International Pvt, Ltd (‘‘TTI‘‘) of Rosh Ha‘ayin scored a victory in the Indian Income Tax Apellate Tribunal, Mumbai (E Bench, ITA No 3939/Mum/2010, Assessment Year 2006-7).
TTI is an Israeli resident company which entered into an agreement with Reliance Infocomm for supply and license of software for RIL‘s wireless network in India. Specifically, the agreement was a ‘‘perpetual, irrevocable, non-exclusive, royalty free, worldwide license to install, use, operate or copy the software and the documentation licensed under the agreement solely for implementation, operation, management and maintenance of RIL‘s Network within India.‘‘
It was agreed that TTI did not have a permanent establishment (essentially, a fixed place of business) in India. This means TTI could not be taxed on business profits because it is an Israeli resident company not doing business in India.
But software is generally protected under copyright law. Was TTI‘s income really royalty income resulting because of the copyright? The Indian Assessing Officer certainly thought so and claimed 10% royalty withholding tax from all such receipts under Article 12 of the India-Israel tax treaty
The TTI claimed the software receipts amounted to ‘‘business profits‘‘ derived outside India, and hence not taxable at all under the India-Israel tax treaty, rather than royalties.
The Tribunal‘s Analysis:
Article 12(3) of the India-Israel tax treaty, the term ‘‘royalties‘‘ means ‘‘payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience‘‘.
In this case, the Tribunal discussed whether there is: (1) use of a copyright, or (2) use of a process?
With regard to the first question (use of a copyright), the Tribunal distinguished between ‘‘use of copyright‘‘ and ‘‘use of a copyrighted article‘‘. This is taken from US law and in fact the Tribunal was influenced by another case involving Motorola, (Motorola Inc Vs. DCIT, 96 TTJ 1). To give a simple example, when a person is using a music compact disc, that person is using the copyrighted article, i.e. the product itself, and not the copyright in that product.
In order to constitute ‘‘use of a copyright‘‘, the transferee must enjoy four rights:
(1) the right to make copies of the software for distribution to the public,
(2) The right to prepare derivative computer programmes based upon the copyrighted programme,
(3) the right to make a public performance of the computer programme and
(4) The right to publicly display the computer programme. If none of these rights are enjoyed by the purchaser, as in this case, there is no ‘‘use of a copyright‘‘.
As for the second question (use of a process), the Tribunal ruled that the consideration received by TTI is not for ‘‘use of a process‘‘ because what the buyer is paying for is not for the ‘‘process‘‘ but for the ‘‘results‘‘ achieved by use of the software. As a matter of fact, under the standard terms and conditions for sale of the software, the buyer is not even allowed to tinker with the process on the basis of which such software runs or to even work around the technical limitations of the software. It would be a ‘‘hyper technical approach totally divorced from ground business realities‘‘ to hold that the use of software is use of a ‘‘process‘‘.
The Tribunal‘s Decision:
The Tribunal ruled that the software receipts were not royalties under the India-Israel tax treaty. Instead, the receipts were business profits derived outside India. Therefore no Indian taxes applied to the software receipts in this case.
Israeli software firms and other hi-tech firms that export their products should always beware of business profit taxation and/or royalty withholding tax in each country concerned. Royalty withholding tax is a tax on sales receipts even if the firm has tax losses in Israel, e.g. from research and developing.
Therefore, Israeli tech firms should check carefully:
(1) their contractual terms of business,
(2) where and how they do business,
(3) Local tax laws in each country.
In this case, a positive Indian precedent was set for Israeli software firms and firms from other countries which have a similar tax treaty with India. Nevertheless, Indian tax law and case decisions are constantly evolving and should be monitored.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.