Software Taxation – Are we on the right track

I was recently working with a start up (in e-commerce sector) and providing them support on the structuring the transactions and identifying the tax exposure of the transaction. The founder of the Company who seemed to be a technology guru, asked me two simple questions:

  1. When my company sells any software, how should the income be treated as, Business Income or Royalty?
  2. How would the buying company record the entry in its books of accounts, as capital expense or revenue expense?

Though this question seems too simple, as a tax professional I knew that our revenue authorities are not yet upto mark on providing clear answers on the same. So I started to explain him from the basics:

  1. Types of software considered as per the Income Tax Act: Though no clear definition of software is given in the income tax Act, but they can be bifurcated into two parts from the revenue perspective:
  • Shrink wrapped software/ copyrighted article:
  • These are available “off the shelf”
  • the customer after purchasing it enters into an End User License Agreement (EULA) with the manufacturer of the software stating that he has obtained only a license to use the software
  • The customer does not get any right to use any of the copyrights, which exclusively belongs to the manufacturer.
  • Computer software/ copyrighted right:
  • This form of software is meant not only for use but also for commercial exploitation.
  • Basically manufacturers of electronic equipment like mobile phones and computers obtain the license to commercially exploit the software produced by another company and modify it as per the requirements of their own product.
  1. Nature of revenue allocated to software: Since no specific definition has been given by the Indian Revenue for software, at various places they have considered the definition pronounced by Organization for Economic Cooperation and Development (OECD) or the Copyrights Act and have bifurcated the income into two parts:
  • Royalty, which includes “transfer of all or any right for use or right to use a computer software, (including granting of a license) irrespective of the medium through which such right is transferred.”
  • Business Income, which is basically normal business profits
  1. Clarity on type of income based on the character of payment as clarified by OECD commentary
  • The character of payments involving the transfer of computer software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the program.
  • The various kinds of rights that may arise out of the arrangements are as follows:
    • Partial right: Payments made for acquisition of partial rights in the copyright (without the transfer or fully alienating the copyright rights) will represent a royalty income where the consideration is for granting of rights to use the program in a manner that would without such license, constitute an infringement of copyright.
    • Limited user rights: Payments made for rights limited to enable the user to operate the program would be classified as business income. The rights transferred in these cases are specific to the nature of the computer programs like copying of the software on the user’s hard drive for use within the business
    • Transfer of technical know how: When the author of the software agrees to supply information or technical know how regarding the software like algorithms or programming techniques then payments for such services are to be classified as royalty income
    • Distribution rights: Payments made in consideration of obtaining the exclusive distribution rights of a particular software within a territory do not constitute royalty income. Instead they are incomes from business as the intermediary gets the right to distribute copies of the software without the right to actually reproduce the same. The logic behind this is that distributors pay income for acquisition of copies of the software and not to exploit the copyright in the software.
  1. Different state courts taking different tax treatment stand on similar transaction
  • With lack of clarity in the definition, different state courts have been taking decisions on their own interpretation
  • In few cases this has led to a single company having two contradictory rulings from two different states on same transaction and same vendor
  1. No clarity on treatment of e commerce transactions/ digital transaction
  • In the case of transactions that permit the customer to electronically download digital products (such as software, images, sounds or text), the payment is made to acquire data transmitted in the form of a digital signal for the own use or enjoyment of the acquirer.
  • There is no-clarity on the tax treatment of such digital transactions.
  1. Treatment of software expenditure
  • Income Tax Rules provide that computers including computer software are eligible for depreciation @ 60%.
  • Recent amendment in Income Tax Act clarified that payment made towards purchase of computer software is royalty.
  • Since the Income Tax Act override the Rules, thus it may be fair to say that expense for software shall be allowed as a revenue expenditure.

Though by the end of the conversation, I got up from the meeting after successfully clarifying most of his doubts, it made me wonder that there is an urgent need of a well settled principle of taxing of royalty transactions in India. This needs to be based on a more relevant criteria taking into consideration all the characterizations, analysis of impact on the underlying copyright and facts of each case so that a more certain and clarificatory decision can be arrived at. In years to come, with technology transfer being the most prevalent way of running businesses, we need to have matured accounting and tax principles to cater to the ever growing Indian market.