A royalty is a sum of money legally required to be paid to a person or business in exchange for the continued use of their assets, such as franchises, natural resources, and works protected by copyright. Musicians get paid royalties when their original songs are streamed on streaming platforms, performed live at concerts, pubs, and restaurants, or utilised in movies. Most of the time, royalties are sources of income created especially to pay song or property owners when they grant permission for another party to utilise their creations.

Delving into Software Royalty

Software royalties refer to the recurring payments made by a licensee to the licensor of a software product for the right to use the software as per the terms of a license agreement. These payments depend on factors such as usage, sales, or revenue generated from the software. The licensee can access the software without owning it, while the licensor earns income from the continued use of their intellectual property. These royalties help compensate the licensor for the development and maintenance costs of the software and establish a mutually beneficial relationship between both parties.

If the payment is classified as royalty, it is subject to a 20% withholding tax on the gross amount. This rate may be lowered by the terms of a Double Taxation Avoidance Agreement (DTAA) between India and the foreign company’s country of residency. ‘Gross withholding tax’ refers to the tax deducted at the source, i.e., by the payer, before they pay the foreign company. It would, therefore, be necessary for the payer to withhold tax at the appropriate rate on a gross basis at the time of payment or when crediting the amount to the foreign company’s accounts.

Types of Software Royalty

India has entered into numerous tax treaties which lead to two categories of royalty:

1. Category A: This category mainly consists of contracts with the United States, United Kingdom, France, Singapore, and other countries. Here, “royalty” includes compensation for the use of literary copyright. Notably, the royalty definition does not extend to include consideration for computer software used under these treaties.
2. Category B: This category relates to Category A, but further includes payments for computer software or programs as royalty. It covers treaties with Russia, Morocco, Trinidad, Namibia, and Tobago. This category expands the meaning of royalty beyond literary works to include payments for software usage.

Is it Royalty or Business Income?

When one talks about software royalties, the essence of “royalty,” as provided in Section 9(1)(vi) of the Income-tax Act, 1961 (“ITA”), is essential. A good example is payments for utilising or transferring intellectual property rights, including licenses, trademarks, and patent rights. The most critical is that these payments are meant exclusively for intellectual property.

Transactions are classified as business income provided they entail acquiring a good instead of an ideational entity during the process, regardless of whether it is an online or offline deal. Consequently, this point is critical in DTAA’s treatment of ‘fees for technical services’ compared with those characterised by copyright, as in the DTAA article. In the ITA or DTAAs, royalties do not include payments made for product purchases, although they may include intellectual property. Specifically, sales revenues are recognised from product sales amounting to monetary transactions made in exchange for either goods or services.

If the aim is to exploit commercial intellectual property rights via side payments, only then will this type of income fall within the royalty income category, but it is not considered so otherwise. Furnished payments are classified based either on the product itself or their intellectual property rights in case there is any doubt as to whether these earnings should be considered.

The Supreme Court’s stance on Software Royalty

The Supreme Court’s recent decision in Engineering Analysis Centre of Excellence v. The Commission of Income Tax & Anr has significant implications for taxing payments related to computer software. The court ruled that payments made by resident Indian end-users/distributors to non-resident software manufacturers/suppliers for the resale or use of computer software do not constitute royalty under Article 12 of the Tax Treaties (DTAA). Instead, the payments were considered akin to simple purchases of goods, exempt from tax deducted at source (TDS) under Section 195 of the ITA. The case addressed various scenarios, including direct end-user purchases, transactions involving distributors, and hardware sales with pre-installed software.

The Supreme Court’s ruling encompassed 86 appeals across four categories of taxpayers: end-users, distributors, foreign vendors, and vendors selling integrated hardware-software products. The court further emphasised that under DTAA, ITA’s provisions only apply to the extent they are more favourable to the taxpayer. It underscored the importance of DTAA definitions in determining tax liabilities. The decision also referenced a circular of the Central Board of Direct Taxes, emphasising consideration of DTAA provisions when deducting taxes at source.

Interplay with the Copyright Act, 1957

The Supreme Court thoroughly examined the Copyright Act, 1957 in this context. It clarified that when a copyright owner transfers any or all rights under sub-sections (a) and (b) of Section 14 for consideration, the recipient becomes the complete owner of those rights. Granting any rights to a licensee through a license agreement could involve royalty payment for relinquishing such rights.

Implication on the End-User License Agreements (EULAs)

Upon reviewing the EULA or distribution agreement, the court determined that distributors were granted only a non-exclusive, non-transferable license to resell the software. Additionally, end-users were given the right to use the software but lacked further rights like sublicensing, transferring, or modifying it beyond the license terms. Thus, the licenses granted did not transfer copyright ownership but imposed usage restrictions on the software.

Conclusion

Recent legal interpretations and tax treaties help shed more light on India’s understanding of software royalties. Thanks to the Supreme Court’s decision, it is now easier for investors to know whether they are making profits on royalties or regular business income from software deals, making it possible to realise whether they pay taxes under DTAA. Do you think this will significantly impact how software companies structure their licensing agreements in India?