A provision made in the Finance Bill 2012-2013 now identifies the purchase of software products from non-resident (foreign companies) as royalty and hence the transaction is subjected to a withholding tax, which is currently 10 per cent of the gross purchase amount with retrospective effect from 1st of June, 1976.
The bill, presented by the Finance Minister, Pranab Mukherjee in the Lok Sabha on the 16th of March, 2012 was aimed at clarifying the controversial issue of taxation of royalties applicable to the software purchases.
"There was a controversy mainly revolving around the issue whether the payment received by non-resident for giving license of the computer software, popularly known as 'sale of software', is chargeable to tax as 'royalty' under clause (i)/ (v) of Explanation 2 to section 9(1)(vi) of the Income Tax Act or under the relevant tax treaty, or is it merely a 'sale of software' i.e. sale of copyrighted articles," explains Rajan Vora, Head of Tax & Controversy Group (Direct Tax) in the Litigation practice of Ernst & Young , India.
"Non resident companies who import standardized, specialized software to India have been treating it as pure business income generated out of the sale of shrink wrapped boxed products," he says.
The amendment narrows the definition of royalty in the case of software purchase.
"If the purchase of software falls under royalty, then it is subjected to a withholding tax that is similar to Tax Deduction at Source (TDS)," says Kaushik Mukherjee, Executive Director, Tax & Regulatory Services, PwC India.
The royalty on withholding tax rates for payments made to NRIs and foreign companies as determined by the Finance Act currently is 20 percent of the gross amount.
A Can of Worms
Does this mean that buyers in India who have purchased software that carries a copyright from overseas and have paid a consideration for acquiring this software will have to pay up a withholding tax on their purchase effective from June 1, 1976?
"Since the proposed amendment is retrospective, it would be retrograde and harsh for Indian companies that have not withheld tax," says Naveen Aggarwal, Partner, KPMG.
"Currently the income tax authorities can only open up to last 6 years of record, but given the volumes of transactions that large business enterprises have made during the given time period, the amount of un-paid withholding tax is huge," says Mukherjee.
Vora on the other hand is also worried about the penalties accrued over the un-paid taxes. "How much the Indian Enterprises will be affected depends largely on the course of action the tax authorities and the vendor companies will take," fears Vora, "It's likely that the entire onus of clearing the unpaid amount till date and the additional tax to be paid on every purchase in the future will fall on the end-consumer."
Despite the controversy surrounding the impact on end-consumers in India, Mukherjee points out that all the confusion is not over here. "Let's not forget that these amendments are "subservient" to the various tax treaties that the home countries of non-resident firms have signed with the Indian government," he explains.
These tax treaties save multi-national companies from the risk of double payments of taxes. Technically, companies are free to choose whether they want to pay taxes as per the local tax laws of the country where they are doing business or taxes applicable as per the tax treaty, which ever they deem beneficial.
However, this factor adds another layer of incertitude. Indian companies and their technical partners would now need to figure out which benefits can they avail from their respective tax treaties, calculating withholding tax at different rates applicable as per various treaties and how do these treaties define royalty.
Gear Up: Analysts Suggest
Analysts believe that the Indian Enterprise should gain more clarity on how these amendments are going to affect them and initiate some course of action or plan for it.
"In any case, to continue claiming the tax treaty benefits, foreign software vendors would now need to provide a Tax Residency Certificate to the tax department in the future," says Aggarwal, "The Indian enterprises making such payments may now be more inclined to apply the Indian withholding tax."
The bill has just been presented in the Lok Sabha and is open to debate before it reaches the Rajya Sabha and the President of India for approval before it becomes the Finance Act.
"Since this explanation has been brought in retrospectively, it is going to run into a big litigation debate. Question will come whether such retrospective clarificatory amendment is constitutionally valid or not," Vora explains.
Irrespective of the fact both Vora and Mukherjee suggest that Indian enterprises should keep a keen eye on the development. "Surely there will be a push back from the enterprises and the government might open the bill to suggestions from business entities and trade bodies," says Mukherjee.
Multiple lawsuits against non resident IT companies are pending in different courts in India, both in high courts as well as the Supreme Court, challenging authorities who have sought to tax income from the sale of software as royalty. This amendment if made an act would open all such litigation cases since 1976.
Once the bill passes the power corridors, these amendments will take effect from 1st of July, 2012.
Excerpt from the Finance Bill 2012-2013 as Presented by the Finance Minister Pranab Mukherjee.
The amendment made to section 9(1)(vi) in the Finance Bill to clarify that the consideration for use or right to use of computer software is royalty by clarifying that transfer of all or any rights in respect of any right, property or information as mentioned in Explanation 2, includes and has always included 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.
(ii) To amend section 9(1)(vi) to clarify that royalty includes and has always included consideration in respect of any right, property or information, whether or not
(a) the possession or control of such right, property or information is with the payer;
(b) such right, property or information is used directly by the payer;
(c) the location of such right, property or information is in India.
These amendments will take effect retrospectively from 1st June, 1976 and will accordingly apply in relation to the assessment year 1977-78 and subsequent assessment years.
THE FINANCE BILL, 2012